Stablecoins Explained: Why Terra and Luna Crash Are Exciting Investors

What is a stablecoin?

Most stablecoins are closely related to a traditional currency, such as the US dollar, or to a commodity such as gold. Investors buy them to store funds and facilitate transactions within the cryptocurrency infrastructure. They are also used for other types of financial exchanges, such as lending, borrowing, or sending payments abroad with less friction than going through a traditional bank.

Their alleged stability has turned these once-obscure tokens into the bedrock of the crypto ecosystem. The collective market capitalization of all stablecoins has grown to $180 billion as of March this year, according to the Federal Reserve.

But don’t let the name fool you: not all stablecoins are stable by themselves.

Some stablecoins have a 1 to 1 relationship to real assets, such as US Treasuries. Some of them are related to bonds whose value can fluctuate.

But it’s the stablecoin’s cousin, the “algorithmic stablecoin,” that sparked panic among investors this week. And while they look similar, computational diversity is, functionally, another beast altogether.

Unstable currency?

Most stablecoins are backed by real collateral such as dollars or cash equivalents. But algal stablecoins are not necessarily backed by any real external asset, as they rely on complex financial engineering to keep their value constant. And when they do fall, they tend to fall hard—industry watchers call this a “death spiral.”

Algorithmic coins are “just a great way to say, ‘We’ll say this is worth a dollar because it is backed by another asset that we also created out of the blue,” says Charles Cascarilla, CEO and co-founder of Paxos, a blockchain infrastructure company.

In the case of TerraUSD, another “flawless” asset is the Luna cryptocurrency.

Here’s how it works:

The problem is that the entire ecosystem depends on traders ratification Luna has value. Once investors lose faith in the system, all bets are off.

Bloomberg columnist Matt Levine wrote: “Any morning, people can wake up and say ‘Wait a minute, I just made up all this, it’s worthless,’ and decided to get rid of Lunas and Terrace.”

This appears to be what happened this week. The wheels started rolling over the weekend, when investors started pulling out of both the Terra and Luna.

“This is exactly the ‘death spiral’ that a lot of people have been anticipating,” said Henry Elder, Head of Decentralized Assets at Wave Financial, a digital asset manager.

what happened after that?

Stablecoin advocates are warning that this is no time to throw the baby in the bath, noting that crypto-backed stablecoins like Tether and USDCoin held steady during this week’s Terra crash.

Investors and regulators on edge

Bitcoin, the world’s largest cryptocurrency, has also suffered from the jittery mood in the cryptocurrency.

Early Thursday, the cryptocurrency was trading around $28,000, down more than 12% in 24 hours. (Bitcoin, like other cryptocurrencies, is traded 24 hours a day, seven days a week.)

Crypto assets are still a small part of the broader financial system. But powerful people like Treasury Secretary Janet Yellen are taking notice, fearful that the situation could create unforeseen and unfortunate consequences for investors of all classes.

In her Senate testimony earlier this week, Yellen commented on Terra’s decline saying that it “simply demonstrates that this is a fast-growing product and that there are risks to financial stability.”

Also this week, Yellen warned that stablecoins remain “vulnerable to threats” because some are backed by assets that may lose value or become illiquid in times of stress.

Crypto evangelists tend to see crashes like Terra as an unfortunate loss, but ultimately help bolster the credibility of the underlying blockchain technology.

“I think the process of sifting through good ideas and questionable ideas ultimately makes the ecosystem stronger,” says Paxos’ Cascarilla. “The economy is switching entirely to the speed of the internet, but the financial system is still running at the same speed as the post office…Unfortunately, there are these moments of creative destruction that actually end up being part of the best ways to narrow things down to what people can They really lag behind.”

—Julia Horowitz of CNN Business contributed to this report.