Wednesday, Jun 29, 2022
International Finance
Banking and Finance Magazine

Are stablecoins a misnomer?

Are stablecoins a misnomer?
The promise of TerraUSD seems to have gone bust for good.

Cryptocurrencies, which had surfaced in the late 2000s with the creation of the first Bitcoin or BTC by the pseudonymous yet well-known Satoshi Nakamoto, had come close to being mainstream in the late 2010s with the advent of the idea of Web3.0.

Cryptos was pegged as an integral part of the next generation of web systems which painted the possibility of a decentralized ecosystem beyond the overarching control of the ‘Big Tech’ and governments. By March 2022, the market cap of all cryptos had reached $1.7 trillion across the globe despite suffering a massive slump in prices since the peak of November 2021.

But now, it seems finally the juggernaut has stopped at least temporarily. The most prevalent and most valuable cryptocurrency Bitcoin itself had taken a massive hit. It was trading only at around $30,000 in mid-May, a massive drop from around double that price from its all-time high of November 2021. This was not an isolated phenomenon experienced by investors of BTC but also all major cryptos like Ethereum, and Dogecoin suffered a massive fall in their values consistent with the crash in the equities market.

While this slump has wiped off wealth to the tune of trillions of dollars from investors irrespective of their risk appetite, it was not very surprising despite the extent of its slide. Cryptos always had the promise of volatility as it had of anonymity. Another key function of stability has been outlined by Lukas Schor, a product manager at Gnosis, a DeFI company. In his blog, he explained that in addition to the two characteristics of being a medium of transactions and a storage of value, stable coins offer a degree of reliance to conduct a transaction without having to worry about too much fluctuation.

“For any currency, stability is crucial to trade goods and services without the risk of either the buyer- or seller-side losing value as a result of the price volatility. For cryptocurrencies specifically, price volatility prevents mainstream adoption of applications built on top of the cryptocurrency protocols,” he eloquently spelled out. He advocated the usage of stable coins as a useful bridge between crypto and centralized finance.

So, what if some investors or regular everyday persons liked the idea of cryptos as a hassle-free anonymous, cross-border currency without its super volatile region. Along came the idea of stable coins in 2014.

What gives stablecoins stability?
Primarily the idea is simple. Suppose there is a cryptocurrency that can always trade at a value equal to a fiat currency like the US dollar or the Great Britain Pound or the Euro. This essentially means that adopters of this cryptocurrency will be assigned a token for every fiat currency parked in a bank account. The benefit of this exercise is that once one has that token, which is unique like currency notes, can be transacted across borders and with complete anonymity over the web. The promise of such crypto stable coins came that since it’s guaranteed for the said fiat currency, one can get back the same once they choose to return the token to exchange or the coin issuer. An example can be that of USDT, which is more popularly known as Tether, which is supposedly equal to a dollar.

As stable coins like Tether got popular, there was an advent of another bunch of cryptocurrencies that promised similar notions of stability. But there was a catch. There was not necessarily a unit of such said fiat currency parked in a bank account for every token issued as the tokens or currencies. Instead, the value pegged at say a dollar or any other central bank-issued currency, was artificially maintained through an algorithm. While it seems possible in thought, for the algorithm to work in actuality there is a need to devise another cryptocurrency on which this altcoin is pegged.

One of the more popular altcoins is TerraUSD or UST which was introduced in September 2020 by a company named Terraform Lab.

“Tether created a new category of digital assets riding on a public blockchain that were backed 1:1 by fiat assets held in a banking institution, which we now call fiat-backed stablecoins. In the wake of Tether (also known as USDT) and USDC, a variety of other fiat-backed stablecoins sprouted up, and the fiat assets under custody (AUC) held by each project ballooned as interest in these coins grew,” explained Arthur Hayes recounting this phenomenon in his blog.

And by mid-May, the company was the eye of the crypto storm even by the wide margins of volatility associated with the crypto ecosystem. A majority of $18 billion worth of investments in the tokens issued by Terraform almost went bust. This in turn triggered a sellout of the entire crypto market with BTC which was already on a losing run since November 2021 shedding further value. Other cryptos irrespective of market size or token value reported crashes with only a few exceptions.

As explained, TerraUSD needed another cryptocurrency to peg on in order to “always” maintain its value close to the US dollar. In this case, Terra said that their algorithm for UST will be based on Luna, another cryptocurrency. Note for the $18 billion worth of UST issued there is no corresponding sum of dollars in the bank anywhere around the globe.

In a possible defense for companies like Terraform, Arthur in the same blog said, “The fundamental issue with this class of stablecoins is that it requires a willing bank to hold the fiat assets that back the token. Not a single Satoshi or Wei of stablecoin transaction fees ends up in the pockets of a banker, but there is a cost to the bank to hold these vast sums of fiat assets. As we know, the destruction of the time value of money by central bankers completely shattered the lending business model of commercial banks — making it a curious policy for them to agree to hold billions of dollars for protocols that aim to disintermediate them, with no identifiable upside.”

Creation and redemption of the stablecoin
Stablecoins are generally created, or “minted,” in exchange for fiat currency that an issuer receives from a user or third party. Many stablecoins claim or expect that the coin can be redeemed at par upon request, in order to maintain a stable value compared to fiat currency. Stablecoins are frequently touted as being backed or supported by various reserve assets.

However, there are no rules for the composition of stablecoin reserve assets, and the information made publicly available about the issuer’s reserve assets is inconsistent in terms of both content and frequency of release between stablecoin arrangements. Based on information available, stablecoins differ in the riskiness of their reserve assets, with some stablecoin arrangements reportedly holding virtually all reserve assets in insured depository institutions or US Treasury bills, while others reportedly holding riskier reserve assets such as commercial paper, corporate and municipal bonds, and other digital assets.

In terms of who can bring a stablecoin to an issuer for redemption and whether there are any limits on the number of coins that can be redeemed, stablecoin redemption rights can also vary significantly. Some issuers are allowed to postpone redemption payments for seven days or even cancel redemptions at any moment under the terms of the agreement, causing significant ambiguity about the timing of redemptions.

The rise of altcoins
It is to be noted that Luna like most other cryptocurrencies are free for trading at the exchange. So how would Terra possibly maintain its promise of UST equalling a dollar? In theory, it was possible, in case the price of Luna drops with respect to the dollar, then Terra would issue fresh tokens of Luna to match the price or do the exact opposite if the price drops.

But what happened, in reality, was far from the original idea that Terraform had sold its evangelists. A majority of the investors or those who held the tokens cashed out on their holdings of Luna and it soon became worthless. In turn, with the loss of value of Luna, those who held UST also lost their confidence in the altcoin and started selling off their Terra deposits triggering a death spiral.

The extent of the phenomenon can be understood by the following drop in price. Luna, whose token was worth $119 on May 4 was worth $0.000189 by the end of May 18. To keep up their promise, Terraform issued 6.5 trillion tokens to keep up with the slump in prices but that did not help the prices as there were no buyers of either Terra or Luna.

According to market observers, until this point in mid-May stable coins including altcoins had maintained their worth close to the US dollar by the margin of a few cents. But in mid-May, the range of stability veered from 95-102% discounting for the crash of USDT.

The last major wobble that was witnessed in this microsegment was in 2020 when Tether and USDC (not the same as USDT) had touched 97 cents and $1.01 once in 2021 for a brief period.

While the mid-May rout had wiped out Tether’s value by close to $8 billion, rival stable coin USDC has made substantial gains. The market value of the coin increased by $3 billion to reach a sum of $51 billion, noted Coinmarketcap. While part of these gains was the confidence enjoyed by USDC from traditional investment behemoths like BlackRock.

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