Stablecoin Explained: Why the Terra and Luna Crash Worried Investors

This week, one popular so-called algorithmic coin crashed, wiping out billions of dollars worth of value in just a few days.

A coin called TerraUSD is designed to keep its value at $1 forever and ever, amen. Instead, it fell to 23 cents on Wednesday before recovering slightly. Early Thursday, it hovered around 60 cents.

For critics of the controversial crypto product, this is the “emperor naked” moment. Or, more pessimistically, the 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 like bitcoin and Ethereum are notorious for price fluctuations that unnerve investors. Stablecoins, as their name suggests, are designed to be stable.

Most stablecoins are hard-pegged to a traditional fiat currency like the US dollar or a commodity like gold. Investors buy them to store money and facilitate transactions in the cryptocurrency infrastructure. They are also used for other types of financial exchange such as lending, borrowing, or sending payments abroad with less hassle than going through a traditional bank.

Their supposed stability has turned these once obscure tokens into the backbone of the crypto ecosystem. According to the Federal Reserve, the combined market value of all stablecoins rose to $180 billion as of March this year.

But don’t let the name fool you: not all stablecoins are stable on their own.

Some stablecoins are linked one-to-one with real assets such as US Treasury bills. Some of them are associated with bonds, the value of which can fluctuate.

But it was the wayward cousin of the stablecoin, the “algorithmic stablecoin”, that caused panic among investors this week. While they sound similar, the algorithmic variety is functionally quite different.

Unstable coin?

Most stablecoins are backed by real collateral such as dollars or their equivalents. But algorithmic stablecoins are not necessarily backed by any real external asset, relying on sophisticated financial engineering to keep their value stable. And when they fall, they tend to fall hard—industry observers 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 out of thin air,'” says Charles Cascarilla, chief executive and co-author. founder of Paxos, a blockchain infrastructure firm.

In the case of TerraUSD, another asset “out of thin air” is the Luna cryptocurrency.

Here’s how it works:

  • Theoretically, an investor can exchange one Terra for a Luna dollar, a sister token whose price is not fixed.
  • Traders who engage in a process called arbitrage can quickly profit from the fluctuations of any asset, creating an incentive to keep Terra’s price stable at $1.00. For example, if Terra drops below the dollar, arbitrage traders swoop in to buy Terra cheaply and trade it for $1 worth of Luna.
  • This ultimately creates an ecosystem where traders trade Lunas and Terras to keep Terra’s value at $1.00.

The problem is that the entire ecosystem relies on traders. believing The moon has value. Once investors lose faith in the system, all bets are off.

“People can wake up any morning and say, ‘Wait, you just made this all up, it’s useless’ and decide to throw away their Moons and Terraces,” wrote Bloomberg columnist Matt Levine.

Looks like that’s exactly what happened this week. The wheels started to fall apart over the weekend as investors started to pull out of both Terra and Luna.

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

What happens next?

Stablecoin proponents are warning that now is not the time to throw the baby out with the water, noting that currency-backed stablecoins such as Tether and USDCoin remained stable during the Terran crash this week.

But on Thursday, growing pressure rocked Tether, the world’s largest stablecoin with an $80 billion market cap. Tether fell to 96 cents early Thursday. CoinMarketCap. Meanwhile, the second largest stablecoin, USDCoin, has stabilized at $1.
Tether CTO tried to reassure investors on Thursday, tweet that the parent company of the coin is still accepting redemption at $1 “no sweat”.
Do Kwon, CEO of Terraform Labs, posted on Wednesday that recovery efforts are underway encouraging investors to “stay strong”. By Thursday, supporters appeared to be struggling to win investor support for the recovery plan. Bloomberg reportedwith reference to people familiar with the matter.

Investors and regulators in tension

Bitcoin, the world’s largest cryptocurrency, has also suffered from deteriorating sentiment in the crypto industry.

The cryptocurrency was trading at around $28,000 early Thursday, down more than 12% in 24 hours. (Bitcoin, like other cryptocurrencies, trades 24 hours a day, seven days a week.)

Crypto assets still make up a small part of the wider financial system. But powerful people like Treasury Secretary Janet Yellen are taking notice, fearing that the situation could backfire and unpredictable consequences for investors of all stripes.

Speaking before the Senate earlier this week, Yellen commented on Terra’s downfall, saying it “just shows that it’s a fast-growing product and that there are financial stability risks.”

Also this week, Yellen warned that stablecoins remain “run-vulnerable” because some are backed by assets that can lose value or become illiquid during times of stress.

Crypto evangelists tend to view a crash like the one with Terra as an unfortunate loss that ultimately helps build trust in the underlying blockchain technology.

“I really think that the process of sifting through good and bad ideas ends up making the ecosystem stronger,” Paxos’ Cascarilla says. “The economy is going all the way to the speed of the internet, but the financial system is still running at the speed of the mail… Unfortunately, there are moments of creative destruction that actually become some of the best ways to narrow things down to something people can actually cling to.” .

Julia Horowitz of CNN Business contributed to the story.

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