What are stablecoins and how did they trigger a crypto market crash?

The prices of popular cryptocurrencies like Bitcoin, Ethereum and the wider crypto market plunged last week, triggered by the crash of so-called stablecoins, a type of cryptocurrency that is supposed to protect buyers from the volatility of digital currencies.

Hundreds of billions of dollars were wiped off crypto’s total market cap, wrecking portfolios as holdings of the TerraUSD (UST) stablecoin and its sister token Luna dropped to almost zero from a combined value of more than $40 billion just before their fall.

The collapse of the Terra blockchain project – which simultaneously played the role of mint, commercial bank, central bank, and even stock market – had many calling it the crypto world’s “Lehman moment.”

The downfall of the Terra token economy, widely viewed as one of the biggest experiments in decentralized finance (DeFi) to date, saw investors cut their losses and move their money to less volatile assets.

Terra had lured in some of the biggest names in crypto onto its blockchain, the likes of Galaxy Digital, Coinbase Ventures, Jump Crypto and many others, not to mention a number of retail investors that ended up posting their despair on social media.

What are stablecoins?

Stablecoins are a form of cryptocurrency that is tied to a reserve asset such as a currency (like the dollar or euro) or a commodity (like gold, oil, or real estate), so as to make the value of stablecoins less prone to volatile swings in price.

For example, Tether (USDT) is pegged to the US dollar, while Pax Gold is tied to gold prices.

This differs from other cryptocurrencies like Bitcoin, which are not backed by anything.

There are different types of stablecoins, too.

First, you have fiat-backed stablecoins like USD Coin (USDC), where for every $1 in USDC there is $1 held in a bank.

Then you have stablecoins which are backed and collateralised by crypto, where for interest-bearing crypto assets, you get stablecoins like Dai or Mim.

Lastly you have algorithmic stablecoins like UST, which are under collateralised, most of which are based on arbitrage opportunities when the coin is “off” the $1 peg.

Investors use stablecoins to protect their money from sudden price swings associated with other cryptocurrencies. On DeFi platforms, stablecoins are used to lend crypto, since the value of the collateral or currency-baked tokens is unlikely to change between the time a customer gets approved for a loan and the crypto lands in the individual’s digital wallet.

Traders also use stablecoins instead of converting more volatile assets into hard cash, which can be expensive and trigger tax implications.

There are roughly 200 varieties of stablecoins on the market, with the three largest by market value being Tether ($74 billion), USDC ($52 billion) and Binance USD ($18.5 billion).

As of Friday, the total market value of stablecoins was $160.6 billion, according to CoinMarketCap.

What caused the collapse?

Stablecoins fell victim to a more significant crypto sell-off triggered soon after the US Federal Reserve raised interest rates by half a percentage point a week ago.

With mounting economic uncertainty combined with higher inflation, investors shifted their portfolios away from riskier assets, including stablecoins and other cryptos. Then Luna’s crash and UST de-pegging dragged broader crypto markets down with them.

Like Bitcoin or Ethereum, Terra has its own blockchain. Its primary product is the UST, an algorithmic stablecoin pegged to the dollar which relies upon code, constant market activity and belief to maintain its peg.

UST’s peg was also theoretically propped up by its algorithmic link to Terra’s base currency, Luna.

The way algorithmic stablecoins work is through a mechanism that encourages arbitrage. Essentially, it is game theory.

For example, if 1 UST is down to 98 cents, then people can buy it and get $1 worth of Luna, gaining a 2 cent profit. If 1 UST is up to $1.02, they can do the reverse – trade $1 Luna for $1 UST and pocket 2 cents.

The “value” of UST came from a lending platform called Anchor, which offered a 19.5 percent yield to anyone who bought UST and lent it to the protocol. Terra also had other mechanisms in place to defend its peg, including billions worth in Bitcoin as a backstop to hold its value.

So, what happened? A death spiral.

Some experts believe that investors with deep pockets attacked the Terra stablecoin by short-selling: they borrowed huge amounts of Bitcoin to buy UST, with the intention of making huge profits when the value of UST fell after dumping all their Bitcoin on the market to trigger a wider panic.

This caused UST to de-peg from the dollar, and a bank run ensued as investors who had earned interest via Anchor scrambled to get out before the linked token Luna also crashed.

Now, UST is worth 0.08 cents and Luna is worth fractions of a penny after being worth as much as $116 in April.

What about regulation?

US lawmakers have been thinking of ways to regulate the cryptocurrency market, and stablecoins have been at the centre of those debates.

Across the Atlantic, the European Commission is considering implementing a hard cap on the daily activity of large stablecoins.

Stablecoins need controlling because they are “backed by assets that may lose value or become illiquid during stress” and are “vulnerable to runs”, the US Federal Reserve said in a report released on Monday.

US Treasury Secretary Janet Yellen said the de-pegging of UST shows the urgency to have a regulatory framework on stablecoins.

“A stablecoin known as TerraUSD experienced a run and had declined in value,” Yellen told a Senate banking committee last Tuesday. “I think that simply illustrates that this a rapidly growing product and that there are risks to financial stability and we need a framework that is appropriate.”

Alternatively, many believe CBDCs (Central Bank Digital Currencies) will fill the gap in the stablecoin market. According to the Bank for International Settlements, 90 percent of all central banks are researching and actively experimenting with CBDCs.

Unlike stablecoins, CBDCs will have the same status as central bank money, which is fully convertible to other forms of legal tender currency.