Stablecoins Explained: Why the Terra and Luna Crash Puts Investors on edge

This week, a popular so-called algo coin crashed into its crater, wiping out billions of dollars of value in just a few days.

The coin, called TerraUSD, is designed to hold its value at $1 forever and ever, amen. Instead, it fell to 23 cents on Wednesday before gaining some ground again. Thursday it hovered around 60 cents.

For critics of the controversial crypto product, it’s an “emperor has no clothes” moment. Or, more pessimistically, a Lehman Brothers moment.

To understand what is happening in this corner of the crypto market, it is important to understand what these newfangled investment products are and how they work.

What is a stablecoin?

Cryptocurrencies such as bitcoin and ether are known for their wild fluctuations in value that make investors nervous. Stablecoins, as their name implies, are designed to remain stable.

Most stablecoins are tightly pegged to a traditional fiat currency, such as the US dollar, or to a commodity such as gold. Investors buy them to store funds and facilitate deals within the cryptocurrency infrastructure. They are also used for other types of financial exchanges, such as borrowing, lending or sending payments abroad with less friction than through a traditional bank.

Their claimed stability has turned these once obscure tokens into the foundation of the crypto ecosystem. The collective market value of all stablecoins has grown to $180 billion in March this year, according to the Federal Reserve.

But don’t let the name fool you: not all stablecoins are stable per se.

Some stablecoins have a 1-to-1 connection to real assets, such as US Treasury bills. Some are linked to bonds, which can fluctuate in value.

But it’s stablecoin’s quirky cousin, the “algorithmic stablecoin” that sparked panic among investors this week. And while they sound the same, the algorithmic variety is functionally a very different beast.

The unstable currency?

Most stablecoins are backed by real collateral such as dollars or cash equivalents. But algorithmic stablecoins are not necessarily backed by any real external assets, and rely on complex financial engineering to keep their value stable. And when they fall, they tend to fall hard — industry watchers call this a “death spiral.”

Algorithmic coins are “just a fancy way of saying, ‘We’re going to say this is worth a dollar because it’s backed by another asset that we’re also creating from scratch,'” said Charles Cascarilla, the chief executive and co-founder. founder of Paxos, a blockchain infrastructure company.

In the case of TerraUSD, that other “out of the blue” asset is the cryptocurrency Luna.

This is how it works:

  • An investor can theoretically exchange one Terra for one dollar worth of Luna, its sister token whose price is not fixed.
  • Traders who participate in a process called arbitrage can quickly make a profit by taking advantage of fluctuations in both assets, creating an incentive to keep Terra’s value stable at $1. For example, if Terra falls below a dollar, they will dive. arbitrage traders to buy Terra cheaply and exchange it for $1 to Luna.
  • This eventually creates an ecosystem where traders trade Lunas and Terras to keep Terra’s value at $1.

The problem is that the whole ecosystem relies on traders to believe Luna has value. Once investors lose faith in the system, all bets are off.

“Every morning people can wake up and say, ‘Wait a minute, you made this all up, it’s worthless,’ and decide to ditch their Lunas and Terrace,” wrote Bloomberg columnist Matt Levine.

That seems to have happened this week. The wheels started to come loose over the weekend, as investors pulled out of both Terra and Luna.

“This is exactly the ‘death spiral’ that many people predicted,” said Henry Elder, head of decentralized assets at Wave Financial, a digital asset manager.

What happens now?

Stablecoin advocates warn that this is not the time to throw the baby out with the bathwater, noting that currency-backed stablecoins such as Tether and USDCoin remained stable during Terra’s collapse this week.

But on Thursday, mounting pressure shook Tether, the world’s largest stablecoin with a market cap of $80 billion. According to CoinMarketCap, Tether fell to 96 cents early Thursday. The second largest stablecoin, USDCoin, meanwhile, remained stable at $1.
Chief Technology Officer of Tether tried to reassure investors on Thursday, tweet that the coin’s parent company still honors redemptions at the $1 level “without a drop of sweat.”
Terraform Labs CEO Do Kwon tweeted Wednesday that recovery efforts were underway, encouraging investors to “stay strong.” On Thursday, backers appeared to struggle to win investor support for the recovery plan, Bloomberg reported, citing people familiar with the matter.

Investors and regulators on edge

Bitcoin, the world’s largest cryptocurrency, has also suffered from the sour mood in crypto.

Beginning Thursday, the crypto was trading at around $28,000, down more than 12% over 24 hours. (Bitcoin, like other cryptocurrencies, trades 24 hours a day, seven days a week.)

Crypto assets are still a small part of the wider financial system. But powerful people like Treasury Secretary Janet Yellen are watching, fearing the situation could cause nasty and unpredictable aftershocks for investors of all levels.

Yellen, who testified before the Senate earlier this week, commented on Terra’s decline, saying it “simply illustrates that this is a fast-growing product and there are risks to financial stability.”

Also this week, Yellen warned that stablecoins “remain vulnerable to runs” as some are backed by assets that can lose value or become illiquid in times of stress.

Crypto evangelists tend to view meltdowns like Terra’s as an unfortunate loss, but one that ultimately helps bolster the credibility of the underlying blockchain technology.

“I really think the winnowing process of good ideas and questionable ideas ultimately makes the ecosystem stronger,” says Paxos’ Cascarilla. “The economy is completely shifting to the speed of the internet, but the financial system is still operating at the speed of the post office… Unfortunately, there are moments of creative destruction that end up being one of the best ways to narrow things down to what people really want. can stand.”

—CNN Business’ Julia Horowitz reported.

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