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Bitcoin, the bellwether for the crypto market, recently took a beating. Blame the stablecoins.
Last week, Bitcoin hit a 52-week low, slumping to $25,402 (£20,360), a level not seen since December 2020. The “digital gold” has since rebounded but, at the time of writing, it was still trading around $30,000 (£23,990).
Crypto and global equity markets have been selling off since the start of 2022, thanks to headwinds as varied as inflation, rising interest rates and the war in Ukraine.
The recent, massive market volatility, however, may be linked directly to the troubles of TerraUSD (UST). This once-popular stablecoin has imploded in a matter of days, losing 95% of its market cap since last weekend.
Let’s take a closer look at the stablecoin market to understand how the breakdown of one popular coin could crash the entire cryptocurrency market in a matter of days.
What are stablecoins?
In cryptoland, stablecoins come in several flavours. But as the name suggests, a stablecoin aims to provide a “safe” digital asset that maintains a stable valuation.
Here’s how stablecoins work. Their value is pegged to the price of another asset, most commonly a fiat currency like the US dollar. The goal is for the stablecoin to maintain the same value as its peg.
With a dollar peg, one stablecoin should always be valued at one dollar, no matter what’s happening elsewhere in the market.
Today, the stablecoin Tether (USDT) is the third largest cryptocurrency by market cap. Both USDT and its fellow stablecoin USD Coin (USDC), are pegged to the US dollar. When you buy $10 of USDT, you can expect it to be worth $10 tomorrow and $10 one year from now.
How does TerraUSD work?
TerraUSD is an entirely different beast than Tether or USD Coin. It’s an “algorithmic stablecoin,” backed by nothing more than the magic of computer code.
With an algorithmic stablecoin, a computer program maintains the crypto’s supply. Once you understand that there’s nothing but code backing up the likes of UST, you begin to see how things could have gone south so quickly.
So let’s dive into the whole mess of TerraUSD, which plunged as low as $0.23 (£0.18), far below its $1 (£0.80) peg. Crypto experts say the mechanisms behind TerraUSD were fundamentally flawed from the get-go.
In the TerraUSD system, a special crypto token called LUNA is used to help UST hold its 1-to-1 peg value with the U.S. dollar.
“This whole system is entirely broken because it rests on a speculative asset—LUNA—to be the collateral,” says Colin Aulds, founder of cryptocurrency storage company Privacy Pros. “The problem is that LUNA was created for the purpose of being collateral simply because the Terra ecosystem needed collateral.”
There was little that was stable, so to speak, behind this stablecoin other than its programmatic language.
Why is Terra (LUNA) crashing?
LUNA was meant to buffer TerraUSD against market volatility, but it succumbed to extreme selling over recent days. Its trading price was knocked down to $0.03 (£0.02), at the time of writing. That’s down 99.9% since May 6.
“It was inevitable Terra crashed as the reliance on using other cryptocurrencies as collateral as well as the minting/burning mechanism of LUNA for Terra was not sufficient to survive any serious market volatility,” says Adam Carlton, CEO of crypto wallet PinkPanda.
In a bid to save TerraUSD, the Luna Foundation Guard (LFG), the nonprofit organisation that supports the Terra network, depleted its entire reserve of $3 billion (£2.4 billion) in Bitcoin. And it was the fund’s dumping of its Bitcoin reserves in a last-ditch effort to save UST that may have contributed to Bitcoin’s volatility.
What’s the future of stablecoins?
With the implosion of TerraUSD, other stablecoins are under a microscope, particularly Tether. Remember, USDT is supposed to be backed by holdings of US dollars – and at time of writing, USDT has a market cap of $82 billion (£66 billion).
Sceptics allege that the organisation that runs Tether does not have $82 billion backing up its coin.
Last week, the market tested this thesis. USDT dipped to $0.97, briefly losing its peg to the U.S. dollar. It has since rebounded to parity, but its future health is now in question.
Crypto market participants expect a degree of slippage – one USDT is likely to be valued very slightly less than one dollar as one stablecoin is riskier than one dollar. But it doesn’t take very many pennies off the peg to vaporise market confidence for a stablecoin.
Collateralized stablecoins like USD Coin (USDC) have proven thus far to be resilient. USDC is still trading at $1, and it even experienced a high of $1.13.
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More stablecoin regulation to come
The unwinding of TerraUSD caught the attention of US Treasury Secretary Janet Yellen, who mentioned the possibility of stablecoin regulations after it was apparent that TerraUSD was in a meltdown and that a framework was needed to guard against the risks.
Edelman says there’s no question that more regulation is needed to protect US investors: “That effort is underway… and I’m confident that regs will be in place within the next couple of years, to everyone’s benefit,” he says.
Cryptocurrency in not regulated in the UK. The UK regulator, the Financial Conduct Authority, has repeatedly warned investors that they risk losing all their money if they buy cryptocurrency, with no possibility of compensation.
