Stable coins have become very popular as many users and investors consider these crypto assets as a pathway between fiat currency and the crypto asset space. These crypto-assets promised stability to their investors unlike other volatile crypto assets like Bitcoin.
These crypto coins as comparatively small in amount of market capitalization and have seen their popularity rise in the area where unstable financial conditions arise like South America. However, as experienced with Terra Luna and its sister currency TerraUSD crashing almost 100percent, stablecoin has also suffered the downfall.
Stablecoins are often tied to traditional currencies such as the US dollar at a predetermined rate. For example, if a stablecoin is tied to the dollar in a 1:1 ratio, the owner of the stablecoin can swap one stablecoin for one dollar and vice versa. Currency pegs are maintained by maintaining fully backed reserves, such as Tether. An algorithm preserved the peg in the instance of Luna.
However, investors, users, and regulators have begun to raise concerns about the potential flaws in these pegging processes. Tether, for example, had traditionally kept a tight lid on the specific reserves it keeps to support the stable token. In principle, it should have enough cash, government bonds, and other cash equivalents to cover all redemption requests.
However, it may be difficult for Tether to sell off its assets during a financial crisis or market volatility when it is likely to face more redemption demands. Furthermore, the corporation must keep a sum equivalent to the value of outstanding tokens, which is now estimated to be approximately $75 billion.
Because the quantity is greater than the deposits held by big banks, regulators are looking into methods to regulate such stablecoins. Tether's value, on the other hand, has remained reasonably constant in comparison to its peer Terra, which lost all of its value in a matter of days.
Unlike Tether, TerraUSD, the third-largest stablecoin by market capitalization, does not have any reserves to underpin its value. It was dependent on another cryptocurrency called Luna to keep its value. When the value of the stablecoin went below $1, a trader may burn the TerraUSD and obtain an equivalent amount of Luna. Similarly, if TerraUSD surpassed $1, traders may burn Luna and get an equivalent amount in TerraUSD.
These trades would keep the supply and demand dynamic in check, preventing the currency from deviating too far from its initial peg. The system is heavily reliant on traders and arbitrageurs to deal with extreme deviations from the peg. Investors appear to have invested about $14 billion in TerraUSD in Anchor Protocol, Terra's founder's lending and borrowing protocol.
However, as Terra plummeted in large quantities, depositors in Anchor withdrew their TerraUSD, and the price fell further without any support. The price did not return to the projected level, and both TerraUSD and LUNA have lost nearly all of their worth. Though Terra's founder, Do Kwon, attempted to rally support for the coin on Twitter, he was unable, and the token continued its downward spiral.
Aside from investors, the experience has demonstrated to authorities the hazards of stablecoins. As previously said, Tether's $75 billion market capitalization is considerable and may cause financial authorities anxiety. Tether was affected by the spread of Luna's collapse. The coin lost value and was quoted at 95 cents on the dollar before resuming its regular value.
Furthermore, central banks in several nations have issued warnings to governments about the growing usage of stablecoins, as well as the possible hazards to the country's financial system and sovereignty.
As a result, to preserve their influence over the financial system while keeping up with emerging developments, these institutions are now trying to construct Central Bank Digital Currencies. The entire incident has taught investors not to rely on liquidity, arbitrageurs, unproven hypotheses, or algorithms. Furthermore, it is feasible that reserve-backed stablecoins will be favored over stablecoins that rely heavily on arbitrageurs to keep the currency pegged.