Stablecoins have been a hot topic in the cryptocurrency world lately, especially after recent events shook confidence in some of the biggest stablecoins. Stablecoins are cryptocurrencies that are pegged to a reserve asset like the U.S. dollar in order to minimize volatility. The goal is to provide the benefits of a cryptocurrency while maintaining a stable value. However, stablecoins rely heavily on confidence, and even the biggest ones have experienced crashes and instability. So what happened and what does it mean for the future of stablecoins?
What are stablecoins?
Stablecoins aim to solve the problem of volatility in cryptocurrencies like Bitcoin by pegging their value to a more stable asset. Most major stablecoins are pegged 1:1 with the U.S. dollar and hold dollar-denominated reserves to back up their peg. The three largest stablecoins by market capitalization are Tether (USDT), USD Coin (USDC), and Binance USD (BUSD).
Stablecoins attempt to combine the advantages of fiat currencies like the dollar, which are stable and widely accepted, with the advantages of cryptocurrencies like decentralization and ease of transfer. They allow traders to move between cryptocurrencies without converting to regular fiat currency. Stablecoins are also used as a way for investors to park funds during periods of high volatility in the crypto markets.
How do stablecoins maintain their peg?
There are a few mechanisms stablecoins use to maintain their 1:1 peg to the dollar:
- Fiat currency reserves – The stablecoin issuer holds reserves of the fiat currency equal to the number of stablecoins in circulation. For example, for every 1 USDT token issued, Tether holds $1 in bank reserves to back that token.
- Overcollateralization – The stablecoin is backed by cryptocurrency reserves that exceed the total supply of stablecoins. This provides a cushion in case the crypto collateral drops in value.
- Algorithmic mechanisms – The supply of the stablecoin is algorithmically adjusted based on demand to maintain the peg. More coins are issued when the price is above $1, and coins are bought back when the price is below $1.
Relying entirely on algorithms has proven risky, so most major stablecoins use a combination of reserves and algorithms.
What happened with stablecoins recently?
The stablecoin market was thrown into chaos in May 2022 when one of the largest stablecoins, TerraUSD (UST), lost its 1:1 peg to the dollar. This set off a chain reaction that impacted other stablecoins like Tether. Here is a timeline of what happened:
May 7 – UST loses peg
TerraUSD (UST) was the third-largest stablecoin with a market cap of $18 billion. Unlike most stablecoins, UST used an algorithmic mechanism to maintain its peg, aiming to eliminate the need for reserves. When UST lost its 1:1 peg and fell below $1, panic ensued among investors. This started a death spiral as holders rushed to sell their UST, pushing the price even lower.
May 12 – UST falls to $0.30
Despite attempts to revive the peg, UST kept plunging. Just a week after losing its peg, it had fallen to $0.30, a 70% drop from the target $1. Billions in value was wiped out and UST lost its spot as a top 10 cryptocurrency.
May 12 – Bitcoin drops
The turmoil severely shook market confidence not just in UST but crypto as a whole. Bitcoin prices plunged from over $36,000 on May 7 to below $27,000 on May 12. Ethereum also experienced huge losses.
May 12 – Stablecoin prices decouple
With UST failing, investors worried whether other stablecoins would also lose their peg. There was a flight to safety as buyers piled into stablecoins they perceived as less risky, like USDC and Binance USD. This caused these stablecoins’ prices to temporarily spike above $1.
| Stablecoin | May 7 Price | May 12 Price |
|---|---|---|
| Tether (USDT) | $1 | $1.02 |
| USD Coin (USDC) | $1 | $1.02 |
| Binance USD (BUSD) | $1 | $1.05 |
May 12 – Tether decouples from $1
As the world’s largest stablecoin with a $70 billion market cap, all eyes were on how Tether’s USDT token would react. Demand surged for USDT as investors saw it as a safer stablecoin compared to non-collateralized options. USDT briefly jumped above $1 because of this increased demand before Tether took action.
May 13 – Tether restores $1 peg
To counteract the effects of extreme USDT demand, Tether executed a $700 million buyback of its tokens. Removing tokens from circulation brought the price back down to $1. Tether relied on its large dollar-denominated reserves to maintain redemptions of USDT.
May – Crypto hedge funds liquidate
The volatility and losses caused a number of prominent crypto hedge funds to face liquidity issues and closure, most notably Three Arrows Capital. These liquidations further drove down crypto prices.
Did stablecoins like USDT “crash”?
Stablecoins like USDT that are backed by reserves did not fully crash like UST did. However, even the biggest stablecoins showed slight instability and decoupling from their $1 peg during this period of panic.
While Tether’s USDT token bounced back quickly, it did reveal vulnerabilities when faced with extreme market volatility and an erosion of overall trust in stablecoins. Its brief spike above $1 demonstrated that USDT is not immune from speculative pressure.
However, USDT’s fundamental backing by reserves and quick actions by Tether prevented a full decoupling or crash. Unlike UST, it was not relying entirely on algorithms and market confidence to maintain its peg. Tether’s large treasury of assets allows it to stabilize supply when needed.
Other collateralized stablecoins like USDC and BUSD also held up relatively well compared to UST. But they too demonstrated cracks with their temporary spikes above $1. Although they quickly rebounded, this showed that skepticism of stablecoins broadly impacted their pegs.
How did exchanges and lenders get in trouble?
The chaos around stablecoins placed major stress on cryptocurrency exchanges and lenders. Here are some ways these entities got into trouble:
Liquidations
As crypto prices dropped, traders who had borrowed money from exchanges to buy coins were unable to pay back their loans. Exchanges had to liquidate their positions in a turbulent market, sometimes at a major loss.
Reduced trading volumes
Trading volumes and transactions fees plummeted across exchanges as investors pulled out of the market. This wiped out a key revenue source when exchanges could least afford it.
Withdrawal surges
Exchanges like Celsius that acted as crypto lenders faced customer withdrawal demands exceeding their available liquidity. This fueled further panic and forced exchanges to halt withdrawals.
Exposure to failed coins
Some exchanges and lenders suffered direct losses from their exposure to crashed coins like UST. For example, crypto broker Voyager Digital revealed $650 million worth of losses from UST.
| Company | Stablecoin Losses |
|---|---|
| Voyager Digital | $650 million in UST |
| Celsius | $200 million in UST |
| Three Arrows Capital | Heavy losses from LUNA and UST |
This toxic combination severely damaged the financial health of many crypto companies. Dozens of lenders and exchanges halted withdrawals, with some like Voyager Digital filing for bankruptcy. The carnage showed just how interconnected crypto companies had become, with the failure of UST and LUNA creating a contagion effect.
What does this mean for the future of stablecoins?
The stablecoin crash injected uncertainty and skepticism into the market. Here are some possible implications going forward:
- More scrutiny of backing and reserves – Regulators will pay closer attention to the assets backing major stablecoins to ensure sufficient reserves.
- Move away from algorithmic stablecoins – Collateralized stablecoins are likely to dominate since confidence in automated stabilization mechanisms like UST’s has evaporated.
- Consolidation around the biggest – Market share and adoption will consolidate around just a handful of the biggest and most trusted stablecoins like USDT and USDC.
- Growth in regulated stablecoins – Regulated stablecoins like USDC that undergo audits could see increased usage by institutions seeking transparency.
- Stablecoin diversification – Crypto investors may diversify across multiple stablecoins rather than relying solely on USDT.
- Advance of central bank digital currencies (CBDCs) – Governments may accelerate development of CBDCs as an alternative to private-sector stablecoins.
While dented confidence raises questions for the stablecoin model, collateralized stablecoins using reserves are likely to remain key cogs in the cryptocurrency system. However, expect increased regulation and oversight of this once lightly-scrutinized corner of crypto finance. Stablecoins face a reckoning and all actors, from issuers to exchanges, now understand the urgent need for transparency and liquidity management.
Conclusion
The stablecoin crash of 2022 stemming from UST’s collapse highlighted flaws and vulnerabilities in stablecoins previously obscured during the boom times of crypto growth. Even stalwarts like USDT showed they are not immune from instability during periods of extreme fear and uncertainty.
However, stablecoins with proper backing and reserves like USDT proved far more robust than algorithmic options. Rapid action by issuers prevented major collateralized stablecoins from fully breaking their dollar peg. Still, cracks emerged in the faith and confidence that are foundational to any currency, whether crypto or fiat.
Going forward, transparency and liquidity are paramount for restoring trust. Stablecoin issuers will face pressure to open up their reserves to audits and regulatory scrutiny. Exchanges must shore up their risk management, lending policies, and liabilities. And investors should diversify across stablecoins rather than assuming any one is completely safe in the tumultuous seas of crypto. The stablecoin storm has calmed for now, but stronger measures are essential to prevent another crisis from sinking the ship.