Wednesday, June 29, 2022

Stablecoins Struggling to Survive the Crypto Crash

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It was a crushing few days for the Terra project, in a week that has been brutal for cryptocurrency as a whole.

In recent days, the TerraUSD (UST) stable coin, which aims to maintain a dollar exchange rate, has decoupled dramatically from the $1 and fell to a low of less than 30 cents on May 10. In the latest update of the saga, the beleaguered project has put its entire blockchain stood still for about two hours on Thursday, freezing user funds until the blockchain resumed.

It’s a tough measure, especially given cryptocurrency’s emphasis on decentralization. “We’ve seen hard forks before, but this is the first time we’ve seen such a large, decentralized blockchain system decide to shut the whole thing down,” said Ronghui Gu, CEO and founder of blockchain security company CertiK.

The chaos has been sparked by a steep slide that has seen $200 billion in value wiped out in one day† Bitcoin only dropped below $25,000 on the morning of May 12, a price not seen since December 2020 and less than half of its peak in November 2021. lost about 20 percent of its value in just 24 hours.

Terra’s troubles started on May 9 when the price of the UST stablecoin began to fall dramatically. Due to the way algorithmic stablecoins work, this caused a huge increase in the supply of the associated Luna cryptocurrency token, which trades against UST to balance the price.

Putting Luna tokens into circulation or removing them was previously sufficient to maintain a consistent price for UST. But the size of the price slides and the corresponding amount of Luna minted – supply more than tripled in a matter of days – sent the two linked cryptocurrencies into a “death spiral” from which neither has been able to recover.

Currently, UST is trading at about 40 cents instead of $1; and the value of Luna is almost completely wiped out, crashing from $100 to about 1 cent

UST value from May 7 to May 12.
Image: CoinMarketcap

Terra’s nightmare week clearly shows that stablecoins, which in theory should maintain a fixed price, can in reality be heavily influenced by larger cryptocurrency market movements – and in turn affect those movements.

Terra is not the only stablecoin experiencing problems in the wake of the cryptocurrency’s downturn. Tether’s USDT stablecoin, the largest in circulation, fell well below its dollar peg to trade at 95 cents on some exchanges on Thursday morning, although the price has since recovered. The steps were significant enough that Treasury Secretary Janet Yellen weighed in against the US House Committee on Financial Services to ensure the events did not pose a significant risk for the financial markets as a whole.

Still, the sudden drop is a reminder that the economy behind most stablecoins is still highly experimental. “There are fiat-backed stablecoins, but people think this is too simple – in the web3 and blockchain world, they want to create big, new ideas and innovations,” Gu said. “That is why so much research is being done on whether it is possible to use algorithms to generate a stablecoin, but so far there are no fully convincing solutions.”

Terra’s future is uncertain, but the sheer amount of unredeemed Terra Coins poses a huge problem for the project. As more coin holders try to cash out, they are likely to devalue the supply of Luna tokens even further, causing what Bloomberg‘s Matt Levine described as “a death spiral”

But Gu is still cautiously optimistic about the broader future for stablecoins. “The crash shows that people have overestimated what can be done with blockchain and web3 in a short period of time,” he says, “but they still underestimate what can be done in five or 10 years.”

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