The sudden fall in the Terra Luna token price from $120 last month to almost zero this May’22 has stirred up the heat among investors. They are not just any other cryptocurrencies but are algorithmic stablecoins, the values of which are either pegged to fiat or other currencies.
What’s with these stablecoins? Let’s take a deep dive into understanding the multiple facets of the topic.
What are Stablecoins?
As the very name says, stablecoins are brought to circulation to address the volatile nature of cryptocurrencies. Hence, each stablecoin value is linked to a specific value of an asset to maintain its price constant.
Though the value of the stablecoin is backed by an asset, each of them operates through different mechanisms. Its underlying value differs based on the asset pegged with it.
Stablecoins came into effect to bring together the benefits of decentralization and transparency while retaining the value of physical-world assets.
In short, stablecoins are “Safe Havens” for decentralized investments, and since the prices are more stabilized, they can be used as a medium of exchange for buying and selling commodities.
Let’s look at the various types of stablecoins and their operations.
Here, stablecoins values are linked with the fiat currencies. Any paper currencies of countries lie as collateral in imparting the value to the stablecoins that may be USD, EUR, and others.
The value of the stablecoin versus the currency is pegged in the 1:1 ratio.
The drawback of Fiat-backed Stablecoins
However, processing the transaction of these types of stablecoins involves the role of centralized banks. This raises the question of transparency, trust, and decentralization of this type of stablecoin.
Example of Fiat-backed Stablecoins:
Commodities such as metals like gold or other precious metals are hooked up with stablecoin to maintain their price. For every stablecoin created, an equal value of gold is saved under the control of any third parties. But, this type of coin’s reliability is less than fiat-based coins.
The drawback of Commodity-collateralized Stablecoins
Since the commodities are kept under the custody of central authorities or any third-party organizations, so they function more like a centralized system.
Example of Commodity-collateralized Stablecoins:
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Stablecoins, whose value is tied with other cryptocurrencies such as Ethereum or Bitcoin, come under this type.
Unlike fiat-based cryptocurrencies, where the pegging mechanism requires to be carried out offline, in crypto-backed coins, all the processes are executed through smart contracts on the blockchain itself.
The drawback of Cryptocurrency-backed Stablecoins
As these coins are collateralized with cryptocurrencies; the mining process is more elaborate because it involves multiple factors. The volatility is also high as crypto assets back them.
Example of Cryptocurrency-backed Stablecoins:
DAI stablecoin from MakerDAO is a crypto-backed stablecoin. It is soft pegged with the US dollar and is collateralized by Ethereum-based cryptocurrencies.
Users can deposit a large proportion of cryptos such as ETH(Ethereum) as collateral and buy DAI coins. Keeping the collateral assets to DAI coins in the 2:1 ratio ensures the liquidity of the DAI stablecoin.
The price value of stablecoins under this type is not supported by any underlying assets. Rather they are maintained by algorithms that balance the demand-supply ratio to stabilize the price.
If the demand increases, the algorithm creates more coin for circulation or burn the coins if the supply is high to keep the value close to $1 at any instant.
The drawback of Algorithmic Stablecoins
Since the process is all maintained algorithmically, balancing the price is too challenging and complex.
Example of Algorithmic Stablecoins:
- TerraUSD(UST) was created as an algorithmic stablecoin where the prices are stabilized by burning and minting between Terra(UST) and Luna tokens.
- If Terra’s(UST) price goes beyond $1, which indicates the demand in supply, the users can burn LUNA to increase UST supply and vice versa. And in turn, the platform incentivizes the users to maintain the stability of UST.
The Stability of Stablecoin
The top-performing cryptocurrencies such as Ethereum and Bitcoin are extremely volatile and cannot be relied upon to make daily transactions.
On the other hand, stablecoins are more stabilized in pricing that they are fit for making financial transactions. The centralized financial organizations and banks that want to upgrade to blockchain technology are welcoming the adoption of stablecoins for payouts.
What caused the TerraLuna Stablecoin crash?
TerraLuna, as discussed in the beginning, is an algorithmically generated stablecoin whose demand is stabilized by LUNA tokens. Anchor protocol, a borrowing/lending platform created by Terraform labs, paid 20% interest for depositing Terra’s (UST) coins on the protocol.
But hefty withdrawals of LUNA tokens from the Anchor protocol caused the price of LUNA tokens to fall to earth. The mechanism meant to maintain the stability of the stablecoin prices thus crashed.
This led to the downfall of Terra tokens, whose value, which is supposed to be $1, dropped to almost zero.
Unlike algorithmic stablecoins, the price value crash possibilities are little to very low in other asset-backed cryptocurrencies.
On an end note,
Stablecoin of any type is circulated widely with a value totaling $180 billion, a 112% rise from $85 billion last year.
Combining the qualities of decentralization and stabilized prices catches the gaze of government bodies and central authorities to rely on stablecoins for instilling a secure and advanced financial ecosystem.
Is bitcoin a stablecoin?
Bitcoin is not a stablecoin as it is volatile. Stablecoins are less volatile and are pegged to a “stable” reserve asset such as gold or the U.S. dollar.
Is stablecoin a good investment?
As stablecoins are pegged to a “stable” reserve, they are considered “safe” for long-term investments.
What is the most popular stablecoin?
Some of the best and most popular stablecoins are Tether (USDT), USD Coin (USDC), Binance USD (BUSD), TerraUSD (UST), and Dai (DAI).
What does stablecoin mean?
Stablecoins are fixed-price cryptocurrencies whose value is tied to another stable asset.