Bitcoin, the crypto market’s barometer, has recently taken a battering. Stablecoins are to blame.
Bitcoin fell to a 52-week low of $25,402 (£20,360) last week, a level not seen since December 2020. The “digital gold” has now recovered, although it was still selling about $30,000 (£23,990) at the time of writing.
Since the beginning of 2022, crypto and global equity markets have been declining due to challenges such as inflation, increasing interest rates, and the Ukraine conflict.
The current, tremendous market volatility, on the other hand, is something exceptional, and it’s directly tied to TerraUSD’s problems (UST). This once-popular stablecoin has plummeted in value in only a few days, dropping 95% of its market capitalization since last weekend.
Let’s take a deeper look at the stablecoin market to see how one prominent coin’s failure might bring down the whole cryptocurrency market in a matter of days.
Stablecoins: a type of cryptocurrency
Stablecoins come in a variety of flavors in cryptoland. A stablecoin, on the other hand, tries to create a “secure” digital asset with a consistent value.
Stablecoins function as follows. Their value is determined by the price of another asset, usually a fiat currency such as the US dollar. The stablecoin must keep the same value as its peg in order to be stable.
With a dollar peg, no matter what happens in the market, one stablecoin should always be worth one dollar.
Tether (USDT), a stablecoin, is now the third most valuable cryptocurrency by market capitalization. USDT and USD Coin (USDC), another stablecoin, are both tied to the US dollar. When you buy ten dollars in USDT, you anticipate it to be worth ten dollars tomorrow and ten dollars a year from now.
What is TerraUSD and how does it work?
Tether and USD Coin are not the same thing as TerraUSD. It’s a “algorithmic stablecoin,” meaning it’s backed only by the power of computer code.
A computer program manages the supply of an algorithmic stablecoin. When you realize that the only thing propping up UST is code, it’s easy to see how things might have gone so wrong so rapidly.
So let’s take a look at TerraUSD, which has plummeted to $0.23 (£0.18), much below its $1 (£0.80) peg. TerraUSD’s processes, according to crypto specialists, were fundamentally wrong from the start.
A specific crypto coin called LUNA is employed in the TerraUSD system to enable UST maintain its 1-to-1 peg value with the US dollar.
“The entire system is faulty because it relies on a speculative asset—LUNA—as collateral,” says Colin Aulds, the founder of cryptocurrency storage firm Privacy Pros. “The issue is that LUNA was formed only for the purpose of serving as collateral for the Terra biosphere.”
Apart from its programmable language, there was little that was steady about this stablecoin.
What is causing Terra (LUNA) to crash?
LUNA was supposed to protect TerraUSD from market volatility, but it has been subjected to heavy selling in recent days. At the time of writing, its trading price had dropped to $0.03 (£0.02). Since May 6, the stock has dropped 99.9%.
“It was unavoidable that Terra fall,” says Adam Carlton, CEO of crypto wallet PinkPanda. “The dependence on other cryptocurrencies as collateral, as well as the minting/burning process of LUNA for Terra, was not adequate to survive any major market turbulence.”
The Luna Foundation Guard (LFG), a nonprofit organization that supports the Terra network, expended its entire $3 billion (£2.4 billion) Bitcoin reserve in an attempt to rescue TerraUSD.And it’s likely that the fund’s desperate attempt to salvage UST by selling off its Bitcoin assets contributed to Bitcoin’s volatility.
Will the cryptocurrency market bounce back?
While the sun may be setting on TerraUSD, the crypto market’s future is not all doom and gloom.
What happened this week, according to Ric Edelman, head of the Digital Assets Council of Financial Professionals and author of The Truth About Crypto, was contagion: “During situations of fear, individuals sell indiscriminately.” Smart investors quickly realize that’s nonsense, and they spot a huge purchasing opportunity.”
Bitcoin and Ethereum values, according to Edelman, will quickly rebound. He believes that too many individuals invested in TerraUSD without fully understanding how the system operated, resulting in the current problem.
What are the prospects for stablecoins?
With the demise of TerraUSD, other stablecoins, like Tether, are being scrutinized. Remember that USDT is intended to be backed by US dollar assets, and USDT has a market valuation of $82 billion (£66 billion) at the time of writing.
Skeptics claim that the company that operates Tether does not have the $82 billion to back up its currency.
The market put this theory to the test last week. The USDT fell to $0.97, losing its peg to the US dollar for a brief period. It has subsequently recovered to parity, but its long-term viability is now in doubt.
Because a stablecoin is riskier than a dollar, crypto market players foresee some slippage – one USDT is likely to be worth somewhat less than one dollar. However, it only takes a few cents off the peg to destroy market trust in a stablecoin.
“The market is clearly demonstrating that collateralized stablecoins are the way of the future,” says Andrew Pesco, Domain Money’s head of investment management.
USD Coin (USDC), a collateralized stablecoin, has shown to be robust. The USDC is still trading near $1, with a recent high of $1.13.
“Despite all of the devastation caused by the Terra foundation’s irresponsible approach to stablecoins,” Carlton adds, “we will see the industry stand up and provide even greater market resilience.”
More stablecoin regulation in the future
The collapse of TerraUSD drew the attention of US Treasury Secretary Janet Yellen, who suggested the potential of stablecoin laws once it became clear that TerraUSD was in a state of collapse and that a framework was required to mitigate the dangers.
More regulation, according to Edelman, is unquestionably needed to safeguard US investors: “That effort is underway… “I’m convinced that regulations will be in place over the next several years, to the advantage of everyone,” he adds.
In the United Kingdom, cryptocurrency is not regulated. The Financial Conduct Authority, a UK regulator, has frequently cautioned investors that if they acquire cryptocurrencies, they risk losing all of their money with no recourse.