LONDON: Most cryptocurrencies have a major problem with price volatility, but one subset of coins is designed to hold constant value: stablecoins.
As cryptocurrency prices plummeted this week and Bitcoin lost around a third of its value in just eight days, stablecoins should be insulated from the chaos.
But an unexpected collapse of fourth-largest stablecoin TerraUSD, which broke from its 1:1 dollar peg, has brought the asset class back into focus.
Here’s what you need to know:
WHAT ARE STABLECOINS?
Stablecoins are cryptocurrencies designed to be protected from the wild volatility that makes it difficult to use digital assets for payments or as a store of value.
They try to maintain a constant exchange rate with fiat currencies, for example by pegging the US dollar 1:1.
HOW IMPORTANT ARE YOU?
Stablecoins have a market cap of around $170 billion, making them a relatively small part of the overall cryptocurrency market, which is currently worth around $1.2 trillion, according to CoinMarketCap data.
But they have gained popularity in recent years. The largest stablecoin, Tether, has a market cap of around $80 billion after rising from just $4.1 billion in early 2020.
The #2 stablecoin, USD Coin, has a market cap of $49 billion, according to CoinMarketCap data.
While data on the specific usage of stablecoins is difficult to come by, it plays a crucial role for cryptocurrency traders as they can hedge against bitcoin price spikes or store idle cash without transferring it back into fiat currency.
In its semi-annual Financial Stability Report on Tuesday, the US Federal Reserve warned that stablecoins are increasingly being used to facilitate leveraged trading in other cryptocurrencies facilitate.
Since 2018, stablecoins have increasingly been used in international trade and to circumvent capital controls, says Joseph Edwards, head of financial strategy at crypto firm Solrise. In particular, the stablecoin Tether is used for trading in and around China and South America, he said.
HOW DO YOU WORK?
There are two main types of stablecoins: those that are backed by reserves, which include assets such as fiat currencies, bonds, commercial paper, or even other crypto tokens, and those that are algorithmic or “decentralized.”
Major stablecoins like Tether, USD Coin, and Binance USD are backed by reserves: they say they hold enough dollar-denominated assets to maintain a 1:1 exchange rate.
The companies say one of their stablecoins can always be exchanged for a dollar.
Asset-backed stablecoins have come under pressure in recent years to be transparent about what is in their reserves and whether they have enough dollars to back all the digital coins in circulation.
TerraUSD is now an algorithmic stablecoin. This means that it has no reserves. Instead, its value was to be maintained through a complex mechanism that involved exchanging TerraUSD coins for a free-floating cryptocurrency called Luna to control supply.
WHAT CAN GO WRONG?
TerraUSD’s stability mechanism stopped working this week as investors lost faith in Luna amid a broader downturn in cryptocurrency markets. TerraUSD price crashed as low as 30 cents.
In theory, asset-backed stablecoins should still hold up.
But Tether also broke from its dollar peg on Thursday for the first time since 2020, falling as low as 95 cents.
Tether tried to reassure investors, saying on its website that holders can still redeem their tokens at the 1:1 rate.
WHAT DO THE REGULATORS SAY?
As regulators around the world try to set rules for the cryptocurrency market, some have highlighted stablecoins as a particular risk to financial stability — for example, when too many people try to cash out their stablecoins at once.
In its Stability Report, the Fed warned that stablecoins are vulnerable to investor runs because they are backed by assets that can depreciate or become illiquid during times of market stress. A run on the stablecoin could therefore spill over into the traditional financial system by putting stress on these underlying assets, it said.
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