The world of stablecoins is crashing and burning. And in today's Finshots we will offer a simplified explainer on how all of this is unfolding

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‌The Story

Before we begin, we have to admit something: we’re no experts on cryptocurrency, stablecoins, or any of these new-age financial instruments. But the bloodbath in the crypto world is too big to ignore. $200 billion of crypto wealth wiped out in just 24 hours!!! That’s insane. So we put our heads together this weekend to try and simplify what’s happening. Yes, it’s going to be very, very simplistic. Maybe even too simplistic and miss a lot of the nuance. But even understanding a teeny tiny bit will help us seem cooler at the next cocktail party, no?

So let’s get right into it.

What on earth are stablecoins?

Let’s say you’re someone who loves the idea of crypto as a medium of exchange. You want to be able to buy and sell things using the magical powers of cryptocurrencies but you know that traditional cryptos like Bitcoin won’t quite do the job for you. They’re volatile. One minute it could be worth $40,000. A few minutes later it’s at $30,000. This is too much turbulence.

And that’s where stablecoins come in.

If somebody told you that they’re willing to take your dollar, park it in a bank account, and extend a token (or a receipt?) in return, you could, in principle, use the token to transact with people. And if this token promises anonymity, and a decentralized borderless ecosystem, that would be great no?

So people began working on a new cryptocurrency. A cryptocurrency that made a very lofty promise — “Our token will always be worth $1, come what may. And if you feel like it, you can just hand the token back to the company and we will pay you back using a dollar.”

In principle, it’s basically pegged to the dollar. Sounds simple, doesn’t it?

But how do these crypto companies even promise such a thing?

Well, just like we described it. You give them a dollar. They park it in a bank account that’s regulated by a central bank. It’s safe and it will always be “backed” by hard cash. It doesn’t just randomly derive a value based on public perception. Instead, you know there’s “real money” backing it.

And so people began using stablecoins as a medium of exchange. They didn’t have to rely on the actual dollar anymore.

And the most famous example happens to be Tether (USDT). The founders of Tether have stated unequivocally that every token they’ve ever issued is backed by a corresponding dollar they’ve stashed someplace. It’s a different matter altogether whether they actually hold this reserve, but the point is — Their promise has convinced enough people to use Tether rather liberally and its popularity speaks for itself.

But there’s another version of these stablecoins — one that uses algorithms. In this instance, there’s no dollar backing the cryptocurrency. Instead, the company says, “Hey, here’s our stablecoin. But instead of dollars, we’ll back it up by this other cryptocurrency that we’re creating. And trust us, we’ll honour the commitment of pegging the stablecoin at $1 always”.

But how can that be? How can you promise that your stablecoin will always be worth $1 when you’re backing it with another imaginary item you whipped out of thin air?

Well, this is where things get complicated.

So, let’s look at this through the lens of Terra or Terraform Lab, the company that’s at the centre of all the mayhem today.

Now back in September 2020, they decided to create a stablecoin and called it TerraUSD (UST). It soon became one of the largest coins in the world. And by May 2022, they had issued tokens worth $18 billion. And if the stablecoin promise were met in its true spirit, there should have been $18 billion in a bank in the US. Except, that wasn’t the case. Like we already noted, it was an “algorithmic” stablecoin. So instead of being backed by cash in the bank, it’s backed by another cryptocurrency Luna — a coin created by the same company.

And to make sure they give it a semblance of stability, they begin with a simple assumption 1 UST = 1 Luna = $1.

You have to believe this. Once this assumption is met, they let Luna trade freely on the exchange. Demand and supply for the coin will ultimately decide the price. If people think Luna is worth something, they’ll bid the price upwards. And if they think Luna is worthless, they’ll beat it down. So technically its value could go from $1 to $10 or from $1 to $0.10.

But this isn’t about Luna. It's about the stablecoin Terra or UST. And for a stablecoin to work well, it has to be pegged to the dollar. Meaning if someone holds one Terra (UST), they should always receive $1 worth of Luna. And whenever Luna trades at a value less than a dollar, say $0.10, the company will issue 10 Lunas for every UST that’s in circulation. And if Luna trades at $10, then they’ll burn excess Lunas to make sure the stablecoin holds its value.

But what if, one day, people wake up and think, “Hey, this Luna thing is pretty useless.”

What if they stop believing in the fairytale?

Well, that is a problem. In fact, at that point in time, the company will have to keep creating more Lunas just to ensure some semblance of stability for UST.

And if that doesn’t work, then the whole thing will collapse.

They call it a death spiral — kind of what happened last week.

So a few days ago, people lost faith in the currency and its ability to function as a stablecoin. It didn’t just happen randomly. Something triggered the selloff, but the end result was pretty ugly. Luna’s price tanked by 99.9% — from over $119 to $0.00008 something. To keep up with the fall in price and ensure stability in UST, they had to mint more Lunas. In fact, the number of Luna tokens in circulation went up from 343 million to more than 6.5 trillion in just a week.

But no amount of algorithmic hokus pokus was going to help.

It’s like when Zimbabwe tried to prevent an economic crisis by printing more money. Once you lose faith in the system, your currency is as good as craft paper and in this case, the UST was as good as dead. Like Luna, its value collapsed too — from $1 to below $0.15.

And while we don’t know what precipitated this avalanche, we do know that the crypto community is pretty shaken by all of this. They are now beginning to question the entire idea of stablecoins — even the ones that are supposedly backed by actual dollars.

Because the thing is — Nobody has seen these reserves.

Take for instance the other stablecoin we talked about earlier — Tether. The company keeps telling everyone that they have “enough” reserves with a 1:1 backing, and yet, they haven’t released audited statements, any actual proof that the reserves exist and have persistently deflected serious questions. Also when journalists went looking for this stash, they came back with more questions than answers.

So really, you have to ask, is the stablecoin really stable? Or is this just one massive Ponzi scheme? You tell us.

Until then…

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