StableCoin Goes Unstable

What is a Stablecoin?

A stablecoin is a digital asset that is designed to maintain a consistent value over time. That means no matter what the market conditions are, your investment in a stablecoin will not lose its value.

Well, at least that’s what they were supposed to do.

Last week TerraUSD (UST), a cryptocurrency that is supposed to stay at $1 is now worth around $0.20.

The crypto community has described this sudden devaluation as a crash on the Terra ecosystem. The Token Luna created to back the UST coin suddenly lost a significant portion of its value as well. Stablecoins come in different flavors, with the most notable ones being tether (USDT), USD coin (USDC), binance USD (BUSD), and DAI. There was also terraUSD (UST), now almost worthless. These stablecoins are collectively worth around $160 billion.

Most stablecoins are collateralized, meaning that they are backed by reserve funds held by the issuing entity. For example, USDT is backed by dollars held in a Tether Ltd. reserve account, while USDC is backed by dollars held in a Circle reserve account. BUSD is similar, with binance holding the dollar reserves.

DAI is different in that it is a collateralized stablecoin backed by a diversified portfolio of crypto assets. Instead of being issued by a centralized entity, it is managed by a decentralized autonomous organization (DAO) called MakerDAO. UST was even more different, as it was not collateralized at all. It was an algorithmic stablecoin powered by the Terra protocol and backed by a crypto token called LUNA. The idea was that the Terra protocol would stabilize the value of Luna, but that didn’t work out so well.

LFG (The Luna Foundation Guard) sold off most of its BTC reserves in an effort to prop up the UST stablecoin, which ultimately failed. As a result, the value of the Luna token has crashed from $80 to below $0.002. LFG confirmed that its remaining reserves have almost completely been depleted as a result of the unsuccessful attempt to defend UST. When this failed, the value of LUNA collapsed as well. Now, almost all of the Foundation’s original $3 billion USD total is gone.

As mentioned above, Terraform Labs (the company behind Terra) laid out a plan to buy $10 billion of bitcoin and other crypto assets through the LFG in order to act as a backstop in case something like this happened. The problem remained, though. UST wasn’t fully collateralized like the other stablecoins in the top 5. Before the collapse, UST’s market capitalization was $18 billion, way more than the nearly $4 billion the foundation had in reserve.

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What makes this different is that when something bad happened, Terra couldn’t handle it.

The undercollateralized, algorithmic stablecoin will fail. The system failed. But if we’re honest, UST was a wild success up until the moment it wasn’t. History should serve as a lesson here when we inevitably will see a successful UST copycat crop up in 2027 or whatever.

We also are incredibly lucky that UST and LUNA aren’t big or intertwined enough to cause mass hysteria across all markets. I honestly believe we were lucky this happened in 2022 and not in 2030. Bloomberg’s Matt Levine put it well:

“Five years from now, if every cryptocurrency goes to zero … well, I don’t know what the next five years will be like, but a plausible story (as of last week anyway!) is that there will be continuing integration of crypto into the real economy. More crypto companies will be big and important and intertwined with other companies; their stock will be in the indexes and they will borrow money from banks and use their own money to finance real businesses. … Crypto platforms will be used for real economic activity; ordinary people will invest their savings in those platforms, and those investments will be used to finance real, non-crypto business activity.”

Over 80,000 BTC from the treasury of the tera Ecosystem, which was worth almost $4 billion, was potentially sold during the market crash. This caused a price reaction, but it’s important to note that the broader crypto market sold off as well because of negative news about (LUNA). Additionally, the current macroeconomic environment is uncertain, and this has caused overall risk sentiment to decrease. However, despite all of this, bitcoin still has a market cap of over $500 billion.

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