As popular assets in the space of cryptocurrencies such as bitcoin see their values rapidly declining, the decline of a certain stablecoin attracts the attention of observers as a possible red flag for the market.
TerraUSD, also known as UST, is a stable coin that has fallen to $ 0.30 this week.
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This is fundamentally at odds with the terrain of the UST and other stable coins, which are supposed to maintain a stable value, usually equivalent to the US dollar.
So what went wrong with this stable coin and what will it mean for the crypto market? Here’s what you need to know.
Stablecoins are a special type of cryptocurrency that is tied to the value of an existing asset, often the US dollar.
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While popular digital currencies such as Bitcoin and Ethereum are known for sometimes volatile fluctuations in value, a solid promise of a stable coin aims to compensate for these fluctuations. This can make cryptocurrencies attractive as a hedge against bitcoin or as an alternative cash store if someone does not want to keep their cash.
Alex Tapscott, managing director of Digital Asset Group at Nine Point Partners, says stablecoins have emerged as one of the “killer applications” of crypto.
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Because cryptocurrencies such as bitcoin have volatile values, stable coins – Tether and USDC – are several popular options – often used as a middle step in exchanging digital assets.
Stable coins also have a clear use case for international money transfers, with individuals and companies being able to send funds using stable coins without paying expensive bank fees, Tapscott said.
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“They are a much more efficient and hassle-free way to move money around the world … This is an extremely important innovation.”
What happened to TerraUSD and Luna?
There is a useful metaphor in traditional finance to describe the collapse of TerraUSD, says Tapscott: running the bank.
“In many ways, the collapse of the UST is basically old-fashioned bank governance for the digital currency era, which makes it kind of fascinating that we’re replaying some of the crises we’ve had in the traditional analog financial world in the digital world,” he said.
When a bank holds your money, it holds only a small percentage of that money in reserve and uses most of it to finance loans and other transactions. In the normal course of business, this is usually not a problem, as money comes and goes in manageable proportions with a stable base maintained for customers to withdraw money in their spare time.
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But if everyone decides they want their money today – say, because they believe the bank will not pay – the institution may not have enough reserves to respond to demands. The bank’s run, led by panicked customers, only increases the chances of the bank failing.
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In the case of TerraUSD, some mass withdrawals from the cryptocurrency earlier this week sparked speculation about the coin’s release, and traders appear to be fleeing the asset amid these fears.
By upsetting the balance between supply and demand, TerraUSD broke its fixed dollar. Her sister coin Luna has also seen its value fall sharply.
Tapscott says there is some speculation in the crypto space that an anonymous trader has prompted a kind of “attack” on Stablecoin. The company behind UST briefly halted trading in the Terra blockchain on Thursday to prevent “management attacks”.
The Terra blockchain was officially stopped at block height 7603700. https://t.co/squ5MZ5VDK
Terra validators have decided to stop the Terra chain to prevent management attacks following severe inflation of $ LUNA and a significantly reduced cost of attack.
– Terra (UST) съ Powered by LUNA @ (@terra_money) 12 May 2022
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But he also says the collapse of the coin could be a reflection of what happens to unproven assets when market conditions deteriorate, something he cites in a popular quote from investment mogul Warren Buffett to describe: ” When the tide comes in, you see who is swimming naked. ”
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What impact will this have on the crypto market?
It remains to be seen whether efforts to return the UST to its previous highs will be successful.
Prior to the collapse, TerraUSD was the third largest stable coin in the world with a market capitalization of about $ 18 billion, making it worth only part of the crypto space for a few trillion dollars.
Tapscott says the damage could be done in terms of market confidence, and that could have spillover effects in the rest of the crypto space.
“The psychological impact is significant because people are now questioning the viability of algorithmic stable coins. They wonder if these attempts at decentralized money will succeed or not. And any crisis in trust in the asset class will take place in other assets, “he said.
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In theory, stable asset-backed coins should be sustainable, however.
But Tether also broke away from its fixed dollar for the first time since 2020 on Thursday, falling to $ 0.95.
Bitcoin is among the crypto assets that have had a bad 2022 so far, with more than a 35% drop since the beginning of the year.
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While Tapscott says this is not the return most bitcoin holders hope for, he is encouraged to see that bitcoin is not alone and that high-growth technology stocks are subject to the same market forces as the popular cryptocurrency.
Although he believes that bitcoin will always be his own store of value, separate from other assets, this gives some consolation to see that he is not alone in the current decline.
“It’s really no different from most other high-tech technology companies.”
What makes TerraUSD different from other cryptocurrencies?
Tether and USDC are examples of centralized stable coins, which means that they have reserves of US dollars held in banks as collateral for the value of cryptocurrency.
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Decentralized stable coins have no real-world equivalents – they are backed by digital assets held in smart blockchain contracts.
TerraUSD is a specialized version of this, called an algorithmic stable coin.
Here’s how it had to work.
TerraUSD maintained its commitment to the US dollar by trying to balance the demand and supply of coins in the market.
When the value of TerraUSD falls below $ 1, holders are encouraged to “burn” the coin and withdraw it from circulation. In return, they will receive a moon worth $ 1, another cryptocurrency.
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Theoretically, a reduction in TerraUSD’s total supply would then push its price back up against the fixed dollar.
It will also work in the opposite direction: if TerraUSD exceeds $ 1, retailers can burn a Luna coin to add another TerraUSD to circulation, increasing supply and lowering the price.
If retailers continue to sell and buy back UST and Luna in this dance, TerraUSD should keep its value around $ 1.
Do algorithmic stable coins work?
This crypto model has been criticized in the past.
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Ryan Clements, a professor at the University of Calgary who studies fintech, predicts similar cases in his 2021 paper, entitled “Built for Failure: The Intrinsic Fragility of Algorithmic Stable Coins.”
He told Global News in an email this week that the premise of the algorithmic stablecoin is essentially a “trust game” based on perceptions of supply and demand, rather than underlying assets of fundamental value like their centralized counterparts.
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“Algorithmic stablecoins are based solely on confidence and confidence in the economic incentives of the main ecosystem of the stablecoin issuer, as a result of which there is nothing stable in them,” he wrote.
“Once investor confidence and demand evaporate, they quickly fall into a deadly spiral – and we’ve seen this in real time over the last few days with UST / Luna.”
Tapscott says that while some decentralized stablecoins such as DAI have shown stability through downturns, attempts to build an algorithmic stablecoin that lives up to its name have failed …
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