If you’ve been following crypto news for the past few months, you have probably seen the word “stablecoin” thrown around a lot. Maybe you’ve even heard of the term “algorithmic stablecoin.” WTF is a stablecoin, and why should you care?
Well, if the names LUNA, TerraUSD (UST), or Do Kwon sound familiar to you, then you might be more familiar with stablecoins than you think! Some of the most well-known cryptocurrencies, such as Tether or USDC, are stablecoins.
A stablecoin is a type of cryptocurrency that is pegged to the price of another asset. This asset can be a fiat currency, another cryptocurrency, or a commodity such as gold. In practice, 1 unit of one cryptocurrency should be equivalent to 1 unit of another asset; for example, 1 USDC is equivalent to 1 USD.
Stablecoins generally offer the benefits of crypto trading (instant transfers, low transfer fees), with the security of price stability while staying in the crypto ecosystem. The selling point of a stablecoin is that its value shouldn’t fluctuate, protecting its price from volatility other cryptocurrencies, like Bitcoin or Ethereum, experience.
According to a Deloitte survey, almost 75% of US retailers are excited to support stablecoins. Retailers are interested in stablecoins because they increase avenues of payment with little risk, increase retailers’ customer bases, and customer satisfaction. Governments are interested in stablecoins because they increase financial inclusion while allowing governments to exert their influence and mitigate risk in the global financial system – see the first ever White House briefing on cryptocurrencies published September 16.
So yes, while we love most stablecoins, not all stablecoins have maintained their value and protected against price volatility as they promise, which is where LUNA, TerraUSD (UST), and Do Kwon come into the picture…
You might’ve heard about stablecoins in association with the TerraUSD (UST) & LUNA crash. If not, no worries – I’ll give you the TLDR.
TerraUSD (UST) is a stablecoin in the Terra blockchain. UST is an algorithmic stablecoin, meaning, UST’s value is not pegged to a fiat currency or cryptocurrency, but instead gets its supposed stability from algorithms that tie its value to LUNA, a token of the Terra blockchain. Unlike fiat-collateralized or crypto-collateralized stablecoins, algorithmic stablecoins don’t have any collateral to assure their value.
Basically, 1 UST was supposed to be pegged to $1, and achieved that through minting or burning (permanently destroying) LUNA tokens. When the price of UST went down, more LUNA was minted, increasing LUNA supply and lowering the value of LUNA. When the price of UST went up, more LUNA was burned, decreasing the supply and increasing the value of LUNA.
On May 9, the price of UST fell from $1 to $0.35 due to an attack. On May 12, the price of LUNA fell from $80 to less than $0.10, since a lot of LUNA had to be minted to attempt to bring the UST peg back up to $1.
This led to a $40 billion crash that contributed to the overall crypto market crash of $300 billion.
The attraction of an algorithmic stablecoin is that it’s truly decentralized, unlike those pegged to, for example, the US dollar. However, the downside is that, by design, there is no collateral to back up the value of an algorithmic stablecoin, unlike other stablecoins. Although the financial losses for most institutions in the LUNA crash were little to none, many regular investors got majorly screwed over.
Do Kwon, the founder of Terra, forked the chain and created Terra LUNA (LUNA). The original Terra blockchain is now community-run and was rebranded to Terra Classic (LUNC). Just last week, LUNC surged after a new tax burn proposal. Similarly, LUNA skyrocketed as well, although the reason why is unknown.
Although the crash of UST and LUNA in May showed the risk of algorithmic stablecoins, the failure can be pinpointed to the fact that UST was an algorithmic stablecoin, which are, in comparison to collateralized stablecoins, known to be much more attack-prone and risk-averse due to the lack of collateral.
Stablecoins are still mostly unregulated around the world. A few months ago, the International Organization of Securities Commissions (IOSCO) released new guidance on stablecoin regulation which applies the international standards for payment, clearing, and settlement on stablecoins.
The EU and the UK are some of the biggest proponents for stablecoin regulation. Both the EU and the UK recently proposed bills on the topic, largely influenced by the crash of UST & LUNA.
In July, the EU addressed stablecoin regulation in their latest bill, Markets in Crypto Assets (MiCA). MiCA largely addresses regulation around stablecoin issuers, including restricting daily transactions to a cap of 200 million Euros ($203 million USD).
The UK’s new bill, currently under review, the Financial Services and Markets Bill, imposes regulation on “systemic stablecoins,” which are stablecoins that have a wide-enough reach and could threaten financial market stability if they fail. These stablecoins are referred to as “digital settlement agencies,” or DSAs. Unlike MiCA, this bill assumes that stablecoin issuers are already fully operational and instead focuses on DSA service providers that are at risk of failure or bankruptcy. DSAs are yet to be defined by the UK Treasury.
Stablecoins are currently used as a means of sending secure peer-to-peer payments with low transaction fees instantaneously. Stablecoins are especially advantageous for sending money overseas, bringing onboard traditionally unbanked people, and providing an accessible and stable currency for those who live in countries with volatile fiat currencies. Meanwhile, regulators are still figuring out how to regulate them and ensure that there is little financial risk and that they remain beneficial for everyone.
Terra Luna was a cautionary tale for stablecoins, and regulation could add a safety net to prevent another market crash from happening which would hurt regular investors like you and me.
This is not financial advice. If you don't want to spend money investing in crypto or Web3 — you don’t have to. The intent of this article is to help others educate themselves and learn.
Akhila Raju is a Product Manager at Dune based out of NYC. Previously, she was an engineer at Coinbase, ConsenSys, and Google, and graduated with a Computer Science degree from UC Berkeley
