Crypto Crash: How Stable Are Stablecoins?

Stablecoins play an important role in the cryptocurrency market. These tokens, whose value is typically pegged to an underlying currency, are supposed to allow for an easy way to exchange digital assets of value in the crypto economy and aid further adoption of crypto activities.

Some of the most popular stablecoins by market capitalization include Tether (USDT), USD Coin (USDC) and Binance USD (BUSD). There are many other stablecoins that also hold an important place in the market today.

But recent history has shown that some stablecoins have their limitations. The cryptocurrency Terra (LUNA), which was one of the most valuable cryptos in the market, collapsed to near zero on May 12. LUNA plummeted about 96% in just a 24-hour period after the network’s stablecoin, TerraUSD (UST), de-pegged from the U.S. dollar and started a choppy descent May 9, creating a crypto bank run of sorts during which users were aggressively selling off LUNA.

“People put too much trust into it too early, allowing it to become the third-largest stablecoin prematurely,” says Brock Pierce, chairman of the Bitcoin Foundation and a leading cryptocurrency investor.

The TerraUSD experiment exposed weakness in the network and the need for improvements to the decentralized stablecoin infrastructure. Investors naturally may wonder what this means for the future of stablecoins and their goal to enable more efficient crypto transactions. Here we take a look at factors that may have contributed to the crash of UST and where the future of stablecoins might be headed:

— How do stablecoins work?

— TerraUSD (UST) crash.

— How UST’s crash affected the crypto market.

— The future of stablecoins.

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How Do Stablecoins Work?

Stablecoins are digital currencies designed to maintain a direct one-to-one peg to a more stable underlying asset, like a national currency. Some of the most popular stablecoins on the market are pegged to the U.S. dollar or a commodity. Given their intended price stability, stablecoins are used to help manage the volatility in the crypto market.

The different types of stablecoins are labeled according to their underlying collateral structure, which can be fiat-backed, crypto-backed, commodity-backed or algorithmic.

Stablecoins allow market participants to move in and out of crypto trades with ease, improving the usability of volatile cryptocurrencies and creating more liquidity in the crypto market. The direct peg to a more stable asset allows market participants to use stablecoins when crypto price swings become difficult to manage.

[READ: Rising Interest Rates and Bitcoin: What Investors Need to Know.]

TerraUSD (UST) Crash

TerraUSD (UST) is an algorithmic stablecoin issued and backed through the Terra (LUNA) ecosystem. That means that instead of the stablecoin being backed by holdings of U.S. dollars, UST maintains its peg to the U.S. dollar through an algorithm that changes with supply and demand for another cryptocurrency.

“This stablecoin relied on an algorithm that minted new or burned existing LUNA to maintain the peg of TerraUSD to the dollar. When TerraUSD traded below $1, new LUNA were minted to purchase the stablecoins, and when TerraUSD traded above $1, the stablecoins were sold and existing LUNA tokens were burned,” explains Walker Holmes, vice president of MetaTope.

As TerraUSD’s price continued to fall, more LUNA was minted to maintain the peg. “As more LUNA were minted, the value of the asset backing the stablecoin quickly headed toward zero,” Holmes says. The Luna Foundation Guard, or LFG, a foundation created to support TerraUSD, purchased billions of dollars in Bitcoin (BTC) reserves to back UST. LFG ultimately sold some Bitcoin holdings and purchased UST to push its price up.

Although UST was conceived as a decentralized finance solution to maintain its one-to-one peg to the U.S. dollar, the experiment fell short. “No matter how much tech or human capital a protocol has, nothing is invincible,” says Holmes. “Projects can and will fail.”

How UST’s Crash Affected the Crypto Market

UST was known as one of the world’s largest stablecoins and was popular for decentralized finance activities on the Terra network. The Anchor lending and borrowing protocol, which allows users to buy UST, lets users earn up to 18% in annual percentage yield, one of the highest yield offerings in the crypto market. Most of the deposits on Anchor were made in UST.

Due to extreme volatility from the de-pegging of UST to $1, Anchor recently proposed cutting UST yield rates to an average of 4%. Meanwhile, the Terra blockchain has halted the network to come up with a plan to rebuild. Several crypto exchanges have even halted trading of LUNA and its stablecoin. Bitcoin also saw a drop in price after LFG sold off its BTC reserves to prop up UST.

Some crypto traders are buying up LUNA with hopes that it will increase again, but many are inclined to avoid a coin that experienced such a huge recent drop, especially if that’s where they have kept a large portion of their holdings.

Investors have learned from UST’s crash both that algorithmic stablecoins have structural challenges and that Bitcoin reserves are not enough to help maintain a stablecoin’s peg to $1.

“That experiment failed, triggering the single-largest value-losing event in the history of cryptocurrency,” Pierce says, but he noted that the failure holds valuable lessons for developers. “I believe that there is a role for an algorithmic stablecoin in the future that is not dependent upon legacy financial infrastructure,” he says.

[SEE: 8 Best Cryptocurrency ETFs to Buy.]

The Future of Stablecoins

In light of the UST debacle, investors may be wondering how successful stablecoins will be in their role of providing liquidity to the crypto market.

Fintech expert Chris Skinner, author of books including “Doing Digital: Lessons From Leaders,” says the UST crash has caused investors to question their trust in the stablecoin structure and what they feel stablecoins actually are and should be. The way other stablecoins work will also be called into question, he says.

Some crypto market participants put their faith in these structures without looking under the hood, Skinner says. Investors should do their research and make sure they understand the risk and exposure involved, he adds.

Experts say the UST crash could actually boost other stablecoins, such as USDC and USDT, and help them grow. “It will give an opportunity for other stablecoins to come into the picture, maybe some new algorithmic experiments,” says Adil Abdulali, head of portfolio management for digital asset management firm Securitize Capital.

Abdulali describes stablecoin competition as “survival of the fittest,” with projects that endure getting stronger. “It’s an adversarial space that keeps coming up with new innovations,” he says. The market moves fast, and those projects that don’t work get swept aside.

“When you get into a situation where the community loses its confidence and there’s a run on the currency, if everyone takes their money out, then it pulls the rug on the marketplace, and that’s effectively what’s been happening with Terra (LUNA),” Skinner says.

For investors, it’s important to view stablecoins as they would any other investment. They need to know what they’re getting into, Skinner says: “Do you feel confident that it’s something that won’t lose your investment? And even if you do feel confident you won’t lose your investment, whatever money you put in there, be prepared to lose.”

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Crypto Crash: How Stable Are Stablecoins? originally appeared on usnews.com

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