Why stablecoins are panicking investors in the crypto world

Within the often frightening world of cryptocurrencies is a small but growing subspecies: “algorithmic stablecoins”, which have alarmed some investors and regulators.

This week, a popular “algocoin” crashed, losing billions of dollars in value in just a few days.

The coin, called TerraUSD, was designed to hold its value fixed at $1. Instead, it dropped to $0.23 on Wednesday (11), before rebounding a bit.

It was hovering around $0.60 on Thursday (12).

For critics of the controversial crypto product, it’s a “naked emperor” moment, a common expression in English that means being afraid to criticize something that is seen as important by others.

Or, more pessimistic, a Lehman Brothers moment.

To understand what is happening in this corner of the cryptocurrency market, it is important to understand what these innovative investment products are and how they work.

What is a stablecoin?

Cryptocurrencies like bitcoin and ether are known for huge swings in value that make investors nervous. Stablecoins, as their name implies, are designed to remain stable.

Most stablecoins are heavily pegged to a traditional currency such as the US dollar or a commodity such as gold. Investors buy them to store money and facilitate business within the cryptocurrency infrastructure.

They are also used for other types of financial exchanges such as borrowing or sending payments abroad with less friction than going through a traditional bank.

The supposed stability has turned these once-obscure tokens into the bedrock of the cryptocurrency ecosystem.

The collective market cap of all stablecoins grew to $180 billion in March this year, according to the Federal Reserve System (Fed), the central bank of the United States.

But don’t be fooled by the name: not all stablecoins are stable, per se.

Some stablecoins have a 1-to-1 parity with real assets, such as US Treasury bills. Some are linked to bonds, which can fluctuate in value.

But it’s the stablecoin’s rebellious cousin, the “algorithmic stablecoin,” that sparked panic among investors this week. And while they look similar, the algorithmic variety is, functionally, another species.

The unstable currency?

Most stablecoins are backed by real-world collateral such as dollars or cash equivalents.

But algorithmic stablecoins are not necessarily backed by any real external asset, relying on complex financial engineering to keep the value stable. And when they fall, they tend to fall hard—industry observers call this a “death spiral.”

Algorithmic currencies are “just a fancy way of saying, ‘Let’s say this is worth a dollar because it’s backed by another asset that we also created out of thin air,’” says Charles Cascarilla, chief executive and co-founder of Paxos, a company of blockchain infrastructure.

In the case of TerraUSD, that other “out of the air” asset is the Luna cryptocurrency.

See how it works:

• An investor can, in theory, exchange a TerraUSD for a Luna dollar, its sister token whose price is not fixed.
• Traders who engage in a process called arbitrage are able to make a quick profit by exploiting fluctuations in any asset — creating an incentive to keep the value of TerraUSD stable at $1. For example, if TerraUSD drops below one dollar , arbitrage traders come in to buy TerraUSD cheaply and exchange it for $1 in Luna.
• This eventually creates an ecosystem in which traders exchange Lunas and Terras to keep the Earth’s value at $1.

The problem is that the entire ecosystem depends on traders who believe that Luna has value. Once investors lose faith in the system, all bets are off.

“Any morning, people might wake up and say ‘wait a minute, you just made this all up, it’s useless’ and decide to get rid of their Lunas and Terras,” wrote Matt Levine, a columnist for Bloomberg.

Looks like that’s what happened this week. The wheels on this locomotive began to fall off over the weekend as investors began to pull out of Terra and Luna.

“This is exactly the ‘death spiral’ that many people predicted,” said Henry Elder, head of decentralized assets at Wave Financial, a digital asset manager.

What happens next?

Stablecoin supporters warn that this is not the time to throw the baby out with the bathwater, noting that currency-backed stablecoins like Tether and USDCoin have held steady during TerraUSD’s collapse this week.

But last Thursday, the mounting pressure rocked Tether, the world’s largest stablecoin, with a market cap of $80 billion.

Tether dropped to 96 cents on Thursday, according to CoinMarketCap. Meanwhile, the second largest stablecoin, USDCoin, held steady at $1.

Tether’s chief technology officer sought to reassure investors on Thursday, tweeting that the currency’s parent is still honoring redemptions at the $1 level “without a drop of sweat.”

Do Kwon, CEO of Terraform Labs, tweeted Wednesday that turnaround efforts were underway, encouraging investors to “stay strong.”

On Thursday, supporters appeared to be struggling to gain investor support for the turnaround plan, Bloomberg reported, citing people familiar with the matter.

Investors and regulators on edge

Bitcoin, the world’s largest cryptocurrency, has also suffered from the sour climate in cryptocurrencies.

As of early Thursday, the cryptocurrency was trading at around $28,000, down more than 12% in 24 hours. (Bitcoin, like other cryptocurrencies, is traded 24/7.)

Crypto assets still represent a small part of the broader financial system. But powerful people like Treasury Secretary Janet Yellen are paying attention, fearing the situation could create unpleasant and unpredictable side effects for investors of all stripes.

Testifying before the Senate earlier this week, Yellen commented on Terra’s decline, saying it “simply illustrates that this is a fast-growing product and that there are risks to financial stability.”

Also this week, Yellen warned that stablecoins remain “vulnerable to runs” because some are backed by assets that could lose value or become illiquid in times of stress.

Crypto evangelists tend to see Earth-like collapses as an unfortunate loss, but one that ultimately helps bolster the credibility of the underlying blockchain technology.

“I think the process of selecting good ideas and questionable ideas makes the ecosystem stronger,” says Cascarilla of Paxos.

“The economy is totally shifting to the speed of the internet, but the financial system is still working at the speed of the post office… Unfortunately, there are these moments of creative destruction that actually turn out to be some of the best ways to restrict things to what people can afford. really support.”

—Júlia Horowitz of CNN Business contributed to this story.