Are Stablecoins Safe? The recent collapse of the stablecoin Terra (also known as UST) sent shockwaves through the crypto market. The event has sparked debate about the use of stablecoins and whether they can be used as a “stable” store of value. In this Tokenmason article, we define what stablecoins are, how they are structured and the purpose they aim to serve.
What exactly are Stablecoins?
Stablecoins are cryptocurrencies that attempt to peg or link their market value to a fiat currency, physical commodity or financial asset. Stablecoins are designed to reduce volatility relative to cryptocurrencies like Bitcoin and Ethereum. Essentially, stablecoins aim to be cryptocurrencies without the volatility.
Stablecoins try to pursue price stability by maintaining a reserve of underlying assets, such as U.S. dollar (USD) as collateral or through algorithms that are meant to control supply. Stablecoins are secured by cryptography using blockchain technology, so no one can forge transactions on your behalf. The demand of stablecoins can be high, so holders of stablecoins can earn interest by lending their stablecoin to others.
Purpose of Stablecoins
Billions of dollars have flowed into stable coins like USD Coin (USDC) and Tether (USDT) as they have become some of the most popular ways to store and trade value in the crypto ecosystem. Stablecoins attempt to bridge the volatility incurred by cryptocurrency and everyday fiat currency due to the “pegging” mechanism.
Pegging works by burning or minting stablecoin. For example, if the price of a stablecoin is too low (relative to a reference like the USD), they can be burned to reduce the supply in circulation, thereby increasing its price. Conversely, if the relative value of a stablecoin is too high, the supply can be increased by minting more stablecoin to lower the price -Are Stablecoins Safe?.
Some of the benefits of stablecoins are discussed below. However, stablecoins are not without their limitations as we’ve seen from the recent Terra collapse (further discussed below).
Types of Stablecoins
In the earlier sections, we mentioned USD Coin (USDC) which is a fiat-collateralized stablecoin. However, there are other types of stablecoins like crypto collateralized and algorithmic stablecoins that use different mechanisms to stabilize their value.
As the name suggests, fiat-collateralized stablecoins maintain a reserve of a fiat currencies such as USD as collateral for the stablecoin’s underlying value. Other forms of collateral can include physical commodities like gold or silver as well as crude oil, but most popular fiat-collateralized stablecoin is collateralized by USD. Examples of fiat-collateralized stablecoins include USD Coin (USDC) and Tether (USDT) and TrueUSD (TUSD).
Crypto-collateralized stablecoins are similar to fiat-collateralized stablecoins, however the main difference is that crypto-collateralized stablecoins are collateralized by other cryptocurrencies and not fiat. Crypto-collateralized stablecoins are typically over-collateralized, in other words there is more collateralized cryptocurrency for the stablecoins given the significant volatility of underlying cryptocurrency. For example, the DAI stablecoin is pegged to USD but collateralized by Ethereum and other cryptocurrencies equivalent to approximately 150% of DAI in circulation -Are Stablecoins Safe?.
Algorithmic stablecoins are the least common form of stablecoin and do not hold reserve assets, instead they utilize algorithms to control the stablecoin’s money demand and supply to stabilize the price. Algorithmic stablecoins are analogous to how a central bank and print and destroy currency, which isn’t actually backed by a physical asset like gold. However, the issuers of algorithmic stablecoin do may not have the same creditability as a central bank and therefore cannot fall back on such advantages in a crisis.
Collapse of Terra
The collapse Terra USD (UST) was an example of an algorithmic stablecoins gone wrong.. UST was meant to maintain a 1:1 peg with USD; however it was not collateralized by any asset or currency. Instead it utilized algorithms to keep its peg through a complex system connected with Terra’s sister cryptocurrency called LUNA.
The idea was, if the UST price fell below US$1, LNA traders could “burn” the coin in exchange for $US1 of new units in LUNA. This would effectively reduce the supply of UST and raise its price. In mid-May 2022, when a large trader dumped $US350 million worth of UST, with that one trade causing shockwaves so significant that other traders started to dump UST. This ultimate broke UST’s peg and caused the price to plummet to 10 cents, while LUNA fell close to zero -Are Stablecoins Safe?.
What we have learned from the Terra incident is that the structure and design of stablecoin is critical to its success. The idea of Terra’s design may have sounded feasible in theory, however a sudden shock can cause the demise of algorithmic stablecoins, such as Terra and fiat or crypto-collateralized stablecoins can be the safer option for storing value.
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We hope you have found this blog useful and learned more about stablecoins and how they work. Please visit our Blog page for more blockchain related news and articles. For example, you may be interested to read our article about cryptocurrency.
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