Are Stablecoins Turning Unstable?

Stablecoins have grown in popularity as many users and investors saw these crypto assets as a bridge between traditional finance and the crypto asset space. These assets promised stability to users unlike other volatile crypto assets such as Bitcoin. These coins, though relatively small, in terms of market capitalisation, have seen their popularity rise in areas with unstable financial conditions such as South America. However, with Terra Luna and its sister currency TerraUSD crashing almost 100 per cent, the stablecoin narrative has been severely affected.

What Are Stablecoins?

Stablecoins are usually pegged at a fixed rate with traditional currencies such as the dollar. For instance, for a stablecoin pegged to the dollar in the ratio of 1:1, the owner of a stablecoin could exchange one stablecoin for one dollar and vice versa. The currency pegs are maintained by having fully backed reserves like in the case of Tether. In the case of Luna, the peg was maintained by an algorithm.

However, investors, users, and regulators have begun raising questions about the possible issues with these pegging mechanisms. Tether, for instance, had previously maintained a tight-lipped silence on the exact reserves it holds to back the stable coin. In theory, it is supposed to hold enough cash, government bonds and other cash equivalents to honour all redemption requests.

However, practically, it could be difficult for Tether to sell off its assets at a time of financial crisis or market turbulence — a time when it is likely to see higher redemption requests as well. In addition, the company must hold an amount equal to the value of outstanding tokens, which should be around $75 billion currently.

The amount is higher than the deposits held by large banks, and therefore, regulators are looking at ways to regulate such stablecoins. However, Tether’s value has been relatively stable compared to its peer Terra, which lost all of its value within a span of a few days.

Why Did Stablecoins Witness A Decline?

Unlike Tether, TerraUSD, the third-largest stablecoin by market capitalisation, had no reserves backing its value. It relied on another crypto currency named Luna to maintain its value. A trader could burn the TerraUSD when the value of the stablecoin fell below $1, in turn, they would receive an equivalent worth of Luna. Similarly, when TerraUSD rose above $1, traders could burn Luna and get an equivalent sum in TerraUSD.

These transactions would keep the supply and demand scenario of the two in balance, and prevent the currency from straying away too far from the initial peg. The system is highly dependent on traders and arbitrageurs to handle excessive deviations from the peg. It appears that investors had deposited around $14 billion in TerraUSD in Anchor Protocol, a lending and borrowing protocol created by Terra’s founder.

However, after Terra fell with heavy volumes, depositors in Anchor withdrew their TerraUSD and the price continued to fall further without any support. The price didn’t return to the peg as was expected, and both TerraUSD and LUNA have lost almost all of their value. Though Do Kwon, the founder of Terra, tried to usher people into supporting the coin on Twitter, he was unable to do so, and the coin continued its downward spiral.

Apart from investors, the episode has shown regulators the dangers posed by stablecoins. As highlighted earlier, Tether’s $75 billion market capitalisation is quite significant and could be a cause of concern for financial regulators. The contagion of Luna’s decline affected Tether as well. The coin lost its value and quoted at 95 cents on the dollar before bouncing back to the normal level.

In addition, central banks in several countries have been warning governments against the rising use of stablecoins, and the potential risks to the country’s financial system and sovereignty. Hence, these banks are now looking to create Central Bank Digital Currencies, in order to maintain their control over the financial system while keeping up with new trends. The entire episode has been a lesson for investors to not rely on liquidity, arbitrageurs, untested theories, and algorithms. In addition, it is possible that reserve backed stablecoins will turn out to be more preferred over stablecoins that are highly dependent on arbitrageurs to maintain the currency peg.

This article was first published here.