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Stable Coins: What are They and How Have They Caused The Recent LUNA Crash?

Cryptocurrencies such as Bitcoin over the past 5 years have seen investors return yields of up to 2000%. Helped by an explosion in investor confidence in the crypto market, even leading the adoption of Bitcoin as legal tender in El Salvador and the Central African Republic.

However, many investors still lack the confidence in crypto currencies quoting their volatility and fears attached to investing in a market in its infancy. Birthed from these fears came “stable coins” one of the first being Tether (USDT), the general principle of these coins was to peg the value of the coin to a fiat currency (USD $, etc.) implying the value of the coin remains stable at $1. This allows investors to store their wealth within crypto markets without exposing their capital to the excess risks associated with crypto currencies and exchange currencies without converting them into regulated fiat currency.

Stable coins have boomed in popularity and their combined value constitutes $160 billion (12%) of all coins owned in the $1.3 trillion-dollar market. TerraUSD is another stable coin with market cap of $18 billion which subsequently crashed following events on 9th May to $0.06. The crash was sparked by large withdrawals and the sale of the coin from an exchange akin to a crypto bank [Anchor Protocol] where owners could lend their Terra and earn interest of 20%. These withdrawals visible on the blockchain caused uncertainty among owners and created a “death spiral” of selling.

Luna token is the sister crypto currency of TerraUSD created by the same people out of Terraform Lab. Essentially, the coin acts as a backstop to help maintain the $1 peg e.g. when TerraUSD price increases an algorithm converts Luna into TerraUSD increasing the supply on the market and thus decreasing the price and vice versa. This is contrary to how other stable coins such as Tether maintain their value whereby they are backed by reserves of the currency they are pegged to guarantee its value, similar to how the pound used to be backed by the Bank of England’s gold reserves. Luna itself had seen a growth in popularity returning over 1000% from May 2021 to April 2022. But it’s inextricable link to TerraUSD saw its price also plummet to $0.000185 sending further shockwaves through the entire cryptocurrency market.

The cryptocurrency market already exhibiting signs of decline took a further blow due to this shock. Bitcoin felt a loss in value of around 28% in the aftermath of the shock as the creator of both Terra and Luna sought to deploy their reserves of $3 billion Bitcoin to maintain the peg, albeit unsuccessfully. The ripple effects saw Ethereum drop below $2000 for the first time since July 2021, and many other popular currencies faltered intuitively because two market-leading coins experienced such sharp declines.

Consequently, this has been drawn to the attention of authorities with stable coins coming under the scrutiny of regulators. Many arguing that the market needs to be brought under government control as crashes like this could threaten the stability of the entire financial market as it grows into the future. Certainly, stable coins like much of the crypto universe are experiencing teething problems while in their infancy but no doubt costly lessons will be learnt by developers and investors alike from the events of the past month.


References/Wider Reading

1 - What happened to TerraUSD’s Bitcoin Reserves? – WSJ Article

2 - Crash of TerraUSD Shakes Crypto. ‘There was a run on the bank’ – WSJ Article

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