Stablecoins: How Their Formation Ties in with Cryptocurrencies

I have no doubt that everyone reading this right now has interacted at least once with a fairly novice concept of the crypto industry called ‘stablecoins’. USDT and BUSD have indeed become an integral part of everyday life for crypto enthusiasts across the globe. 

It goes without saying that stablecoins provide users with an incredible convenience and minimal gas fees for transactions. In a broad sense, these are the primary reasons why the community at large values stablecoins and likely couldn’t imagine pursuing crypto-related activities without them. But have you ever asked yourself what the nature of this type of asset is and how other cryptocurrencies affect them? 

That’s exactly what I’ll be discussing in today’s article, so don’t go anywhere until you’re fully acquainted with what I have to say.  

To begin with, stablecoins are cryptocurrencies whose value is tied or pegged to either the value of another currency, another commodity or a financial instrument. Their purpose is to provide an alternative to the highly volatile yet popular cryptocurrencies (like BTC, ETH, etc.) that are less suitable for widespread use in transactions.

The market capitalization of stablecoins has grown from $5.6 billion as of January 2020 to $152.19 billion USD in mid June 2022. What’s more, they’ve started to take on more and more diverse functionality in the crypto-asset system. Initially, stablecoins were created to provide security against crypto volatility and a bridge for trading crypto assets.

In addition to the above mentioned use-cases, the advent of decentralized finance (DeFi) applications has given stablecoins another utility. These days, their role includes providing liquidity to the DeFi market. The main stablecoins – Tether, USB Coin and Balance USD – have dominated the market for a long time, accounting for about 90% of stablecoins’ total market volume. 

Today, I don’t touch on this topic by chance. No matter how useful stablecoins are, they also have a flip side, since the volatility of the cryptocurrency market threatens the very foundation of stablecoins. Despite their wide range of undeniable advantages, stables are not without problems. I will outline these below.

Basically, the whole crypto economy can be expressed in two words — price fluctuations. The price of cryptocurrencies, NFTs and digital blockchain-based assets can actively and quite wildly fluctuate throughout the day, which is a commonplace occurrence. However, the only island of stability present in the entire crypto space is (and should always remain) stablecoins.

The decline is hitting stablecoins most painfully, since they were created precisely to never deviate in price from their peg to the US dollar or another fiat currency. The most grievous example is the loss of the TerraUSD (UST) stablecoin tied to the US dollar, which was unable to withstand the pressure from traders.

Initially, like many cryptocurrencies, Terra used its own blockchain and its main product was the TerraUSD (UST) stablecoin, which many crypto traders used to ‘safely’ store their assets when the DeFi market was volatile.

The value of some stablecoins is secured by their own reserves, so even if investors decide to withdraw from the project, there will be enough money in the fund to cover the dip at once.

However, UST is an algorithmic stablecoin that’s based on code, constant market activity and trust. Its PEG coefficient (which helps it to assess the fairness of the asset’s price) was, in theory, supported by algorithmic binding to the base currency – Terra Luna.

This is what happened. Wealthy investors borrowed huge amounts of Bitcoin to buy UST so that they could make profits from the surplus when LUNA’s value dropped. This is a strategy known as ‘short’ selling.

This in turn led to the fall of UST against the US dollar and it was followed by a massive withdrawal of funds. Investors hurled all their efforts into quitting the project as soon as possible, until they lost everything. Now, the LUNA cryptocurrency associated with Terra has also drastically depreciated. 

At the end of May 2022, the UST stablecoin was worth about $0.10 and LUNA was worth a fraction of a cent, despite it trading at $116 back in April. The savings of many investors in Terra and LUNA have disappeared in a matter of days, even hours in some cases.

The first thing to pay attention to is the reluctance of the project team to face this force majeure. For them, the collapse of LUNA was no less of a shock to them than some kind of national economic crisis. 

The panic decisions made by the team led to the coin falling “to the bottom”. One such decision was to expand the issue of LUNA to 6.5 trillion. Another was the repeated suspension of the project. All this caused nothing but continued negativity and rejection on the part of investors.

Do Kwon, Terra’s co-founder and the CEO of Terra Labs, expressed the idea to restart the network with a billion-dollar issue. The community offered to release a hard fork with a new token in order to somehow hush up the situation. However, many experts reacted with hostility to this notion, even though, I believe, the founding team did its best to keep the project afloat.  

As a result, Terra’s reputation suffered extreme damage. When it comes to money, people have tenacious memories.

In addition, the case of Terra’s collapse calls into question the relevance of all stablecoins as a phenomenon. In fact, all such coins are tied to fiat money, which are in turn, tied to the printing press. This means that whoever issues fiat money can at any time let some kind of stablecoin take its place.

LUNA’s story is quite instructive in the sense that a beautifully advertised offer doesn't always turn out to be something worthwhile. At the same time, we shouldn’t  forget that there were traders who shorted the coin’s future and made a profit.

Summing up, we studied the phenomenon of stablecoins together in some depth, learned what their use-cases are and addressed the way cryptocurrencies affect them. Undoubtedly, this article is no more than a drop in the ocean of information about such coins, but it certainly serves to provide you with a basic understanding of this topic. 

I hope this material was useful to you and the knowledge gained will allow you to analyze this situation and help you make the right decisions in the fullness of time. I’ll continue to follow the news flow on this topic and if I find something in future worth knowing, I’ll bring it to your attention. So make sure you follow my personal blog.