Over the past week, news of the TerraUSD (UST) stablecoin becoming un-pegged from the U.S. dollar has reverberated throughout the crypto world.
To help make sense of it all, we’re looking at what happened and why. But before we jump into the recent events with Terra and LUNA, we need to look at what stablecoins are, starting with the purpose of they serve.
What Is the Purpose of Stablecoins?
While crypto’s volatility can mean both significant gains and losses for traders, its price fluctuations make it difficult to price goods and services.
Say you own a car dealership that accepts payments in U.S. dollars (USD) or Bitcoin. Let’s also assume that to make a profit on your top-selling vehicle, which lists at $60,000, you need to sell it for no less than 75% of that price.
If your customer pays $45,000 in USD, you can reasonably assume that money will give you about the same buying power today as it had three months ago or will have in six months. Thus, you’ll turn a profit, albeit a small one.
But let’s say it’s 10 am on May 5, 2022, and a customer agrees to pay 1.13 Bitcoin for the car-$45,000 in USD at that time. What happens when, eight hours later, that same 1.13 BTC now equals just $41,173 and you have yet to convert that Bitcoin into USD? Over the course of the day you’ve now lost $3,000.
If the market was to go up before the dealership converted to U.S. dollars, then they might have stood to profit more than originally thought. However, that’s not been the case just yet-as of May 20, Bitcoin hasn’t returned to its May 5 valuation. Of course, that doesn’t mean it won’t. But if your dealership needs the cash, how long can it wait?
Clearly, this instability as a medium of exchange presents a problem for widespread crypto adoption. Stablecoins aim to solve for crypto’s volatility by maintaining a set value, often $1 USD.
What Are Stablecoins?
Essentially, the purpose of stablecoins is to facilitate the usage of cryptocurrency as a medium of exchange. Cryptocurrencies like Bitcoin and Ether can be quickly converted into stablecoins to later be converted into another crypto or fiat currency-while in theory holding a constant value.
How stablecoins accomplish this, though, varies considerably. There are four types of stablecoins:
1. Fiat-Backed Stablecoins
The most common type of stablecoins, these are collateralized by traditional currencies. Often this is the U.S. dollar, which has long played the role of global reserve currency. That means that for every $1 in stablecoin created, there should be $1 in USD, euros, or whatever fiat currency the stablecoin is backed by, in its treasury. Likewise, for every $1 taken out, one stablecoin is “burned” to maintain balance.
Examples of fiat-backed stablecoins: GYEN, PAX, USDC, USDT
2. Crypto-Backed Stablecoins
Backed by other cryptocurrencies, these stablecoins are typically over-collateralized to guard against extreme price fluctuations. Crypto-backed stablecoins might hold as much as 150% of their market cap to ensure sufficient liquidity.
Examples of crypto-backed stablecoins: BUSD, DAI, MUSD
3. Commodity-Backed Stablecoins
Though less common, these stablecoins use commodities as collateral-most often gold, but also silver, oil, and real estate. In a way, investing in these stablecoins gives you exposure to other alternative investments.
Examples of commodity-backed stablecoins: PAXG, XAUT
4. Algorithmic Stablecoins
Algorithmic stablecoins are more complicated in that they’re not backed by “real-world” assets. Rather, they’re controlled by smart contracts. To ensure a steady 1:1 peg, tokens are minted (added to circulation) or burned (removed from circulation).
Examples of algorithmic stablecoins: FORTH, RAI, UST
So now that you can answer the question, “What are stablecoins?” and understand that the purpose of stablecoins is to maintain a steady value against other currencies, you may be wondering why people and institutions hold them as investments.
How Investors Make Money with Stablecoins
Primarily, the purpose of stablecoins is to provide crypto holders the option to sell a coin or token and then hold their funds without being required to immediately convert to USD or another cryptocurrency.
Nonetheless, stablecoins present an opportunity to turn a profit. Investors do this by way of what is called arbitrage.
Arbitrage is nothing new. For centuries, people have sought to profit from buying currencies and commodities on one exchange and then selling them on another. In 1800s England, this might have meant buying gold in one city, where the exchange rate was on the low side, and then promptly selling that currency in another city, where the exchange rate was slightly higher. (Though admittedly this sounds like a bit of hassle given the transportation methods of the time.)
As then and now, the goal of arbitrage is to profit off marginal price discrepancies. In crypto, this could mean purchasing and selling on separate exchanges, just moments apart. And because we’re typically talking about variances as slight as buying at $0.989 and selling at $1.006, profiting from this practice usually requires significant transaction quantities. For this reason, most arbitrages involve large, institutional investors.
Additionally-and this almost goes without saying-for this process to work, you need both buyers (demand) and sellers (supply). This point is particularly important for understanding what went wrong with Terraform Labs’ TerraUSD (UST) stablecoin and LUNA cryptocurrency.
How Did TerraUSD Lose Its Peg?
TerraUSD is not the first algorithmic stablecoin. Nor is it the first financially engineered stablecoin to lose its peg. Famed investor Mark Cuban previously called for their regulation when another algorithmic stablecoin, IRON, became unpegged from the U.S. dollar.
In the case of UST, the stablecoin relied on an algorithmic relationship with its sister token, LUNA, to maintain its peg to the U.S. dollar.
If the price of UST fell below $1, traders would be incentivized to burn TerraUSD, in turn reducing the supply and bringing its price back to $1. For this, the trader would be awarded $1 of newly minted LUNA. The opposite, then would occur if UST exceeded its $1 peg.
Though previous attempts to use financial engineering to create stablecoins have seen mixed results, for the most part, this strategy worked for the Terra ecosystem. Until it didn’t. And that’s where arbitrage comes back in.
Arbitrage and Algorithmic Stablecoins
Concerns were already brewing back in March, when Terra co-founder Do Kwon announced that the Luna Foundation Guard (LFG) was buying billions of dollars worth of Bitcoin in the event of a liquidity crisis. (LFG is a non-profit organization tasked with ensuring the success of UST and LUNA.)
Despite these measures, May 9 saw Terra begin to tumble from its $1 peg to slightly over $0.17 the morning of May 13, according to data from CoinMarketCap. Similarly, LUNA saw its value fall from more than $80 on May 5 to just $0.00003616 on May 13.
Remember that we talked about arbitrage as one way people make money off of stablecoin trading. It’s not the only purpose arbitrage serves. In fact, arbitrage plays a key role in maintaining the peg by making markets more efficient. Essentially, by taking advantage of slight pricing discrepancies, arbitrage prevents even wilder fluctuations.
However, this only works when traders are confident in the value of the peg. Following a series of events, it quickly became clear last week that investors were not confident in LUNA’s value.
This lack of confidence led to a “bank run,” as investors rushed to pull their money out in an effort to minimize their losses. Absent collateral (like USD), algorithmic stablecoins rely on a healthy dose of belief, both on the part of sellers and buyers. In the case of UST and LUNA, investors lost faith in their ability to regain the $1 peg, resulting in a supply that far exceeded demand.
Plans to Rescue Terra LUNA
At the time of writing, it’s not clear what’s next for UST, LUNA, or the Terra blockchain. The Terra blockchain and LUNA have since been halted, and on May 27, trading of UST and Wrapped LUNA, or WLUNA, will be suspended from Coinbase, as they have been from other exchanges.
Meanwhile, Terra’s Do Kwon announced measures to save LUNA and the Terra blockchain via a software fork, as well as to “compensate remaining holders of TerraUSD.” Forks are a topic for another day, but just know that they represent a split in the original code of a blockchain, whereby a new line of code represents a new blockchain.
What’s Next for Stablecoins?
To be clear, stablecoins serve a specific purpose. How they achieve that purpose varies greatly, though.
One thing, however, is almost certain: Regulators in the United States and abroad are looking closely at stablecoins and the function they serve. As crypto becomes increasingly intertwined with traditional finance, we should expect them to be making recommendations and establishing rules designed to prevent similar failures.
Additionally, the U.S. Federal Reserve is already looking at creating its own digital currency. As are other central banks around the world. While the Fed hasn’t made any public commitments, TerraUSD’s collapse could expedite the U.S. government’s foray into a digital currency, which could serve a stablecoin-like function. However, whether the crypto community would embrace a government-controlled digital currency is yet to be seen.
Regardless, the events surrounding UST and LUNA have had a profound impact on the crypto ecosystem, with an estimated $45 billion of wealth lost. Nonetheless, crypto holds immense long-term potential for individuals, businesses, and governments alike.
And remember, crypto is a highly volatile asset. Before investing in coins or tokens, we strongly encourage you to do your due diligence. If you’re unsure, consult a trusted financial advisor before investing. No matter how bullish you are on a particular Web3 project, stock, asset class, or what have you, that old adage remains true…
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