What the Heck Is a Stablecoin, and Shouldn’t They Be Stable?

The Simple Sum

01 Sep 2022

The world of crypto is no stranger to volatility.
Bitcoin, Ethereum, and other cryptocurrencies experience wild price swings that make them hard to use as a means of exchange.
Enter stablecoins — cryptocurrencies that peg their value to an existing asset, and offer crypto holders a way to enjoy the benefits of digital currency (e.g., transaction speed and low fees), without the volatility.

For stablecoins to stay stable…

… they need to be backed by something they can “peg” their value to. This is called collateral, and there are generally three types:

Fiat-backed: Coins backed by a national currency (e.g., USD) that match the fiat currency in reserve to the number of coins in circulation.

Cryptocurrency-backed: Coins backed by another cryptocurrency (e.g., BTC, ETH), that typically keep the cryptocurrency in reserve higher than the coins in circulation to account for crypto’s volatility.

Algorithm-backed: Coins that use an algorithm or “smart contract” to peg the stablecoin to another crypto token that helps ensure the stablecoin remains, well, stable.

As you can probably imagine, algorithmic stablecoins are a bit controversial — technically, they aren’t backed by anything.

One such stablecoin…

… is TerraUSD (UST), which is pegged to another crypto token called Luna. The smart contract between the two dictates that UST holders can always trade one UST for $1 worth of Luna tokens. Per Bloomberg’s Matt Levine, this relationship helps keep the price of UST stable at $1 through a pair of arbitrage trades that can happen if UST moves above or below $1:

If UST trades above $1, people can buy $1 worth of Luna and exchange them for one UST, and instantly profit
If UST trades below $1, people can buy one UST for under a dollar and exchange it for $1 worth of Luna, and instantly profit

While this mechanism has traditionally kept the price of UST in place at $1, the recent panic in crypto has caused it to unravel. The value of one Luna has dropped from ~$81 to one cent in the last week. Predictably, no one wants to buy it anymore.

As a result…

… the price of UST (which, again, should always be $1), has dropped as low as 30 cents. But it’s not just algorithmic stablecoins that are struggling. Tether, a fiat-backed stablecoin that’s pegged to the dollar, dropped below 96 cents yesterday morning. With the broader crypto market still turbulent, the next week could determine if “we’re all going to make it” after all.