While the world’s largest crypto asset is receiving its fair share of attention amid the wipeout, most of the focus was on a different class of cryptocurrencies, known as stablecoins. Unlike ‘regular’ cryptocurrencies, which are highly volatile, stablecoins are designed to have a fixed value – typically $1.
Crypto-quake: On Monday, the stablecoin terraUSD (aka UST), which runs on the Terra blockchain, “broke its peg” to the dollar after investors seemingly lost faith in the project. That seemed to trigger a wider crypto crash, with bitcoin falling below $30,000 for the first time since July 2021 and dragging other top cryptocurrencies down with it.
Then on Thursday tether, the largest stablecoin of all with a $80 billion market cap, also broke its peg to the dollar, falling to as low as 94 cents. Tether is a cornerstone of the crypto ecosystem, so this sent bitcoin and other cryptocurrencies into freefall.
Credit: Yahoo Finance
Game over: By Friday the gig was up for UST, which plummeted to around 14 cents. Luna, its ‘sister token’, which is meant to help UST maintain its peg to the dollar, was worth $0 as investors abandoned the project altogether.
Major exchanges in India and around the world, including Binance, quickly suspended trading in UST and Luna.
In a Twitter thread, Binance CEO Changpeng Zhao explained the reason behind the company’s decision.
“An exponential amount of new Luna were minted due to flaws in the design of the Terra protocol. Their validators have suspended their entire network, resulting in no deposits or withdrawals possible to or from any exchange,” Zhao said.
“Some of our users, unaware of the large amounts of newly minted Luna outside the exchange, started to buy Luna again, without understanding that as soon as deposits are allowed, the price will likely crash further. Due to these significant risks, we suspended trading,” he said.
A told-you-so moment: Stablecoins have long been controversial in the crypto community. They were created as an alternative to the high volatility of regular cryptocurrencies. Stablecoins maintain their value by being tied, or “pegged”, to a currency such as the US dollar or a commodity such as gold.
This makes them useful for managing crypto investments as they directly connect fiat money to these digital assets.
But critics have said that many stablecoins are in fact highly risky investments, prone to severe bouts of illiquidity, and have the ability to do some serious macroeconomic damage if left unchecked.
Given what we’ve seen over the past week, they may have a point, especially with the new generation of stablecoins such as terra.
Types of stablecoins: First-generation stablecoins, such as tether, are backed by actual assets – or at least they’re meant to be. Though Tether has claimed its tokens are backed 1:1 by US dollars, the group has been criticised for its lack of transparency on its holdings. Last year it was fined $41 million by the US Commodity Futures Trading Commission for making misleading statements about its reserves.
But second-gen stablecoins, which include UST, are even more controversial. Known as ‘algorithmic stablecoins’, they maintain their value using complex software, not actual assets like bonds or gold. The lack of physical assets in reserve means they’ve been harder for regulators to rein in.
How algorithmic stablecoins work: UST runs on the Terra blockchain alongside its ‘sister token’ Luna.
The Terra protocol tries to keep the price of UST at $1 by ensuring its supply always meets the demand for it. It does so through price arbitrage between UST and Luna, using a complex set of algorithms.
When UST is trading at more than $1, it implies demand is higher than supply. The protocol automatically incentivises users to mint more UST by burning Luna and make a profit off the price difference.
This lowers the price of UST by increasing its supply and increases the price of Luna by reducing its supply. Users continue this arbitrage process until UST returns to $1. When UST falls below $1, the protocol incentivises users to do the opposite – burn UST and mint Luna – until UST rises to $1.
For a while the system worked, keeping UST stable at $1 – until this week.
Abandon ship: The entire Terra ecosystem, like most of crypto, relies on traders and investors having faith in Luna’s value – once enough of them lose faith, the gig is up. That’s exactly what happened last weekend, when investors began pulling out of both UST and Luna, triggering the crash on Monday.
By Tuesday, UST was at 60 cents, down 40% as the sell-off continued. Terra’s creators tried to stabilise the token by throwing money at the problem, but in vain. On Wednesday, UST dropped to 30 cents. By Friday, UST and Luna were history.
So, what’s next? In a word, regulation. Amid the turmoil this week, US Securities and Exchange Commission chairman Gary Gensler accused crypto exchanges of “trading against their customers”. He also pointed out that major stablecoin projects such as Tether, USD Coin and Binance USD are affiliated with large exchanges.
Gensler told Bloomberg, “I don’t think it’s a coincidence. Each one of the three big ones were founded by the trading platforms to facilitate trading on those platforms and potentially avoid AML (anti-money laundering) and KYC (know your customer).”
By Zaheer Merchant in Mumbai.
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That’s all from us this week. Stay safe.