They are believed to be the proverbial islands of peace in the stormy seas of cryptocurrency. However, as it turned out, it was one of these underpinnings of the cryptosphere that stuck to dragging every cryptocurrency down with it. The irresistible forces of a crumbling global economy met with these supposedly immovable commodities, demolishing one of them, with its value tanking for nothing.
What we are talking about are stablecoins or crypto tokens that are designed to remain at a fixed price even if the price of an underlying currency (say Ethereum) changes. As the Ethereum website describes them, stablecoins are basically IOUs for a traditional fiat currency like the US dollar. Therefore, stablecoins such as USDC or Tether are collateralized against the US dollar and valued at $1 for each stablecoin. Cryptographically secure, they were created to serve as a centralized safe haven amid extreme crypto volatility. However, their most important role is as an intermediary between fiat currencies and crypto. If you’ve dabbled in crypto trading, you would know that using fiat currency all the time is just too clumsy; As long as there is a slow settlement, prices can change several times. Thus, stablecoins act as intermediate currencies that lubricate the wheels of crypto exchanges. Some stablecoins have found some interesting off-chain uses. In December, Myanmar’s opposition ‘government’ recognized Tether, the world’s largest stablecoin, as the official currency.
However, when the value of the world’s largest stablecoin, TeraUSD, fell by 95% in a matter of days from falling to zero with a peak value of $35 billion, the entire ‘stable’ building was in danger of being disrupted. The Luna Foundation Guard, the governance organization behind Terra, first tried to shore it up by selling off its entire $3 billion reserve of bitcoin, which in turn pushed the latter’s price sharply downward. The Earth went under the crypto ecosystem, because a large stablecoin like Terra is like a tectonic plate with a lot going on. A slight movement off the $1 peg is manageable, but a collapse could be catastrophic.
But why did Terra fall? And what next? Globally, riskier assets have seen widespread selloff, but there are probably three specific reasons. At first, Terra was designed differently from fiat-collateralized tokens. It is an ‘algorithmic stablecoin’ backed by nothing but the Financial Times “The Magic of Computer Code” (on.ft.com/3Gnmntf), in which a computer program manages demand and supply. There is a special crypto token called Luna, which was meant to help Terra hold this 1-to-1 peg with the dollar. This is in contrast to Tether, which is claimed to be backed entirely by dollars or government securities. “This whole system is completely broken because it rests on a speculative asset—Luna—to be collateralized,” says Colin Aulds, founder of cryptocurrency storage company Privacy Pros. “The problem is that Luna was created on purpose to have collateral because the Terra ecosystem needed collateral.” Second, Terra was offering 19% interest for holding crypto. Although some encouragement is common, this high figure has long been rotten. Third, Luna was founded by Do Kwon, a founder who called himself “the main maniac”. It was not at all confidence-inspiring.
While Terra was clearly overly risky, Tether has its own problems. Tether had around $82 billion worth of coins and it is highly unlikely that its issuers would hold that many dollars as collateral. Tether has been fined several times by the authorities and has now started posting financials that show the breakdown of its reserves. However, Tether as well as other large stablecoins such as Dai and USDC are holding their $1 price peg, which has given investors confidence that the entire crypto financial system will not crumble. The founder of Terra has proposed a blockchain split as a possible solution, although the cryptosphere is wary.
Top US officials have spoken of the need for regulation. While doing so, they must go back in history. In the Americas of the 1800s, hunters and cowboys at the border faced currency shortages. At that time the US had no ‘fiat’ paper currency, only gold and silver coins. But some states allow banks to print their own notes, which can be redeemed for US coins. Like stablecoin issuers, some banks did not bother to hold equal reserves. These banks came to be called ‘wildcats’, probably because their branches were in remote areas where wild animals roamed, better to prevent people from cashing their notes.
The Wildcats are back in crypto incarnations, some of them walking out their ‘stable’ doors.
Jaspreet Bindra is the founder of Tech Whisperer Limited, a digital transformation and technology advisory practice.