Cryptocurrencies like Bitcoin and Ethereum are notorious for their extreme fluctuations in value that make investors anxious, and stablecoins, as their name suggests, are designed to stay constant.
In the world of cryptocurrency, there are small, but growing subspecies known as “algorithmic stablecoins” that have some investors and regulators ringing alarm bells.
This week, one of the popular currencies known as algo went down, wiping billions of dollars from its value in a few days.
The coin called TerraUSD, is designed to keep its value at $1, forever. Instead, it fell to 23 cents on Wednesday, before regaining some of its gains. It was hovering at about 60 cents early Thursday.
To understand what is happening in this corner of the cryptocurrency market, it is important to understand what these new investment products are and how they work.
stablecoin
Cryptocurrencies such as Bitcoin and Ethereum are notorious for their extreme fluctuations in value that make investors anxious. Stable coins, as their name suggests, are designed to remain stable.
Most stablecoins are closely related to a traditional currency, such as the dollar, or to a commodity such as gold. Investors buy them to store funds and facilitate transactions within the cryptocurrency infrastructure. They are also used for other types of financial exchanges, such as lending, borrowing, or sending payments abroad with less friction rather than going through a traditional bank.
Their alleged stability has turned these once-obscure tokens into the bedrock of the crypto system. The collective market capitalization of all stablecoins has grown to $180 billion as of March of this year, according to the Federal Reserve.
But don’t let the name fool you: not all stablecoins are stable by themselves.
Some stablecoins have a 1 to 1 relationship to real assets, such as US Treasuries. Some of them are related to bonds whose value can fluctuate.
unstable
Most stablecoins are backed by real collateral such as dollars or cash equivalents. But algorithmic stablecoins are not necessarily backed by any real external asset, as they rely on complex financial engineering to keep their value constant. And when they fall, they tend to fall hard – what industry observers call a “death spiral”.
Algorithmic currencies are “just a cool way of saying,” that this is worth a dollar because it is backed by another asset that we also created out of thin air, according to Charles Cascarilla, CEO and Co-Founder at Paxos. In the case of TerraUSD, the other asset is the cryptocurrency Luna.
Here’s how it works:
An investor could, in theory, exchange one Terra for a dollar from Luna, a sister token whose price has not been determined.
Traders who engage in a process called arbitrage can make a quick profit by exploiting volatility in any of the assets – creating an incentive to keep Terra’s value constant at $1.
For example, if the price of Terra falls below the dollar, arbitrage traders will buy the Terra cheap and exchange it for $1 from Luna.
This eventually creates a system in which traders exchange Lunas and Terras to keep the Terra’s value at $1.
The problem is that the entire system relies on traders who believe that Luna has value. Once investors lose faith in the system, all bets are off.
That seems to have happened this week. The wheels started rolling over the weekend, when investors started pulling out of both Terra and Luna.
What happens next?
Stablecoin advocates are warning that this is not a time to go to extremes, noting that crypto-backed stablecoins like Tether and USDCoin held steady during this week’s Terra crash.
But on Thursday, mounting pressure rocked Tether, the world’s largest stablecoin with a market capitalization of $80 billion. Tether fell to 96 cents early Thursday. Meanwhile, the second largest stablecoin, USDCoin, settled at $1.
Tether’s chief technology officer sought to reassure investors on Thursday, tweeting that the coin’s parent company was still honoring retaliations at the $1 level “without effort.”
Investors and regulators on edge
Bitcoin, the world’s largest cryptocurrency, has also suffered from the tense mood in the cryptocurrency market. Early Thursday, the cryptocurrency was trading at around $28,000, down more than 12 percent in 24 hours.
Crypto assets are still a small part of the broader financial system. But powerful people like US Treasury Secretary Janet Yellen are afraid that the situation could create unpredictable and bad consequences for investors of all classes.
Crypto evangelists tend to see crashes like Terra’s as an unfortunate loss, but ultimately help bolster the credibility of the underlying blockchain technology.