Stablecoins Explained

Jun 14, 2022

Bitcoin and other cryptocurrencies have gained significant popularity over the past couple of years with billions of dollars flowing into this asset class. We have all learned how volatile cryptocurrencies can be compared to traditional financial instruments like stocks and bonds. However, a subset of cryptocurrencies, whose goal is stability and capital preservation, are called "stablecoins."

Historically, stablecoins have been hyped as a relatively safe and conservative investment. Many investors in stablecoins use their investment to generate a high yield. In a world where it is hard to find yield, something marketed as safe and high yielding grabs attention. But unfortunately, we have learned the hard way that these may carry more risks than intended. For example, the recent collapse of a stablecoin called TerraUSD has sent shockwaves through the cryptocurrency universe and has cost investors billions.

What are Stablecoins?

Stablecoins are a cryptocurrency minted on a blockchain that you can buy, sell, and trade on an exchange, just like other coins. The difference is that instead of being "mined," like Bitcoin, a stablecoin derives its price from the value of another asset. In other words, a reserve asset backs its price to avoid price fluctuation. There are four types of stablecoins, each with its reserve asset.

  • Fiat – Backed by a fiat currency, such as the U.S. dollar.
  • Commodity – Backed by a commodity, such as gold.
  • Cryptocurrency – Backed by another more established cryptocurrency.
  • Algorithmic – Uses an algorithm to keep the value stable by controlling supply.

TerraUSD

A stablecoin called TerraUSD (UST) recently experienced a massive drop in value, causing panic throughout the crypto world. UST is an algorithmic stablecoin that operates in the Terra ecosystem. UST is backed by an algorithm tied to the cryptocurrency LUNA. The algorithm works to keep the price of UST in equilibrium.

However, due to external reasons (under debate), there was a selloff in UST and LUNA simultaneously to the point the algorithm could not keep up. The results were catastrophic.

To put this into dollar terms, on May 6, 2022, the price of one UST was right around $1.00—where it's designed to be. On the same day, the price of one LUNA was about $80.

Fast forward one week to May 13, 2022, and the price of one UST traded as low as $0.14. That same day, the price of one LUNA was about $0.000037. That is not a typo. Nearly $43 billion of market cap was wiped out in less than one week between these two cryptocurrencies. It is still unknown if either will recover.

This selloff sparked panic, which bled over into other cryptocurrencies. For example, the stablecoin "Tether" dropped below its $1 price point to about $0.95 before rebounding. Bitcoin and Ethereum also dropped to or near their 52-week lows.

If you are thinking of investing in one of these coins, it's probably safest to stay with one backed by a fiat currency or commodity. Unfortunately, the lack of regulation in this space means there is no way to know if a stablecoin is actually backed by anything. If fraud is occurring, it usually only comes to light after a period of stress.

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Prior to implementing any investment strategy referenced in this article, either directly or indirectly, please discuss with your investment advisor to determine its applicability. Any corresponding discussion with a Bedel Financial Consulting, Inc. associate pertaining to this article does not serve as personalized investment advice and should not be considered as such.

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