The cryptocurrency market was in for a brutal, terrible bloodbath last week. While Bitcoin was down around 12%, Ethereum followed closely on the heels with a 19% fall. The global markets, too, lost about $400 billion worth of value due to the deep dive taken by the crypto markets.
Here’s the thing: Most cryptocurrencies are prone to extreme price fluctuations; no surprises there. But in the case of last week’s bloodshed, an unexpected participant played truant. Stablecoins, as they are known, are usually considered to be the calmer, steadier cousin of the otherwise volatile cryptocurrencies.
This is because stablecoins do not depend on market factors to ascertain their value. Instead, they derive by pegging themselves to the value of a reserve currency like the dollar, or any commodity. Having such an asset as backing makes them less prone to the rollercoaster that the crypto markets usually are.
As a rule, most stablecoins consistently maintain a 1:1 ratio with their peg of choice. This simply means that every 1 DAI or USDT is equivalent to 1 unit of their underlying currency, which in most cases is the dollar.
It’s when this peg breaks loose that havoc breaks in. Let’s have an in-depth examination of what happened and how to identify a solid stablecoin.
The Downfall of Terra
Less than 30 days ago, LUNA was trading at $99.24. Today, its value has diminished to less than a dollar. Trading now at a meagre $0.0002458, LUNA stood at the edge of wipeout last week, with its market value plunging by more than 99%.
With no immediate recovery in sight, most Indian cryptocurrency exchanges like WazirX, CoinSwitch Kuber and CoinDCX have already delisted LUNA from active trade. But LUNA is not alone.
LUNA is just one part of the Terra ecosystem that also offers UST, which is an algorithmic stablecoin.
Steven Enamakel, Co-Creator, MahaDAO, puts it succinctly: “There are essentially two kinds of stablecoins — collateralised stablecoins and algorithmic stablecoins, also known as uncollateralised stablecoins. Collateralised stablecoins are always backed by some collateral for every stablecoin in circulation.”
As an example of a collateralised stablecoin, consider a USD coin. For every US $1 coin in circulation, there will be a physical reserve of $1 backing it.
“Whereas, algorithmic stablecoins maintain their stable value via an algorithm. TerraUSD was an algorithmic stablecoin. Previously, there have been many similar failed attempts namely — Empty Set Dollar, Basis Cash etc,” continued Enamakel.
The Algorithm that Powered LUNA-UST Ecosystem
In essence, TerraUSD has no physical reserves of dollars as collateral. Instead, it depends completely on its sister coin LUNA to stabilise its market price.
Like Darshan Bathija, co-founder & CEO, Vauld, explains, “Algorithmic stablecoins depend on 2 tokens – the stablecoin and a cryptocurrency that backs the stablecoins; and the algorithm regulates the relationship between these two assets”.
Here, the fundamental relationship relied on the burning and minting of these coins. Every time a TerraUSD is sold, one LUNA is minted or created in the system, and every time someone purchased a TerraUSD, one LUNA was burnt or destroyed from the ecosystem.
This mechanism was what maintained the necessary equilibrium. Every time the value of TerraUSD fell below $1, more LUNA coins were minted. This would drive up the demand and hence the prices of the now-scarce stablecoins in the system.
Similarly, if TerraUSD inched beyond the $1 threshold, more LUNA coins were burnt. That would bring down the demand for the stablecoin due to their excess supply and therefore level the prices back to normal.
But such a mechanism is not without its share of flaws. Enamakel says, “In the absence of collateral backing of a stablecoin, a death spiral occurs that brings down the entire ecosystem”.
And that’s what happened with TerraUST. Suddenly, the market saw huge amounts of TerraUST being withdrawn (almost $2 billion) from lending protocols and immediately dumped back in the market.
This was way more supply of TerraUST that the market could absorb. To bring back balance, more LUNA coins had to be minted. But such was the level of mass selling that had ensued for TerraUST after it lost its 1:1 peg that LUNA coin’s production skyrocketed exponentially, reducing its value to mere pennies.
As Vikram Subburaj, CEO, Giottus Crypto Exchange, puts it, “Stablecoins have an inherent risk of de-pegging and are under increased scrutiny post the collapse of TerraUSD (UST) ecosystem and brief de-pegging of Tether (USDT) last week. Multiple governments, including the US, are considering a crackdown that restricts their use”.
“While they give flexibility to investors as a medium of exchange, we do not recommend investors to lock capital in them,” he elaborated.
What is the Right Stablecoin?
Edul Patel, Co-Founder & CEO of Mudrex, says algorithmic stablecoins presumably have a better trust factor fundamentally. However, he advocates for distributing one’s discretionary holdings across different stablecoins and not concentrating them in a single coin as a prudent strategy.
“One of the best ways to pick a stablecoin would be to check the kind of audits that were conducted. If the audit was done by a questionable party, it cannot be trusted. However, the legitimacy of audits cannot be a foolproof reliable factor. The time period of existence of the stablecoin can also be an important guiding factor,” he added.
Bathija agrees. “The method to identify the right stablecoin is to do your own research. Don’t do anything with your money that you don’t understand. Take some time to learn the underlying mechanics, project’s reliability, the collective trust a coin’s community places in the project.
“Choosing the right exchange to store your assets can make all the difference during market volatility. While buying and hodling cryptocurrencies until the price goes up is a great investment strategy, you could also earn a passive income on your crypto till you decide to sell it,” he signed off.
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