The latest source of volatility – and panic – in the crypto markets? “Algorithmic” stablecoins

By Allison Morrow, CNN Business

In the often confusing world of cryptocurrencies, there is a small but growing subspecies known as “algorithmic stablecoins” that have investors and regulators sounding the alarm.

This week, a popular so-called “algo coin” crashed, wiping out billions of dollars in value in just days.

The coin, called TerraUSD, is designed to hold its value at $1, forever and ever, amen. Instead, it fell as low as 23 cents on Wednesday before recovering ground. It was hovering around 60 cents early Thursday.

For critics of the controversial crypto product, it’s an “emperor has no clothes” moment. Or, more pessimistic, a Lehman Brothers moment.

To understand what is happening in this corner of the crypto market, it is important to understand what these new investment products are and how they work.

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What is a stablecoin?

Cryptocurrencies like bitcoin and ether are notorious for their large swings in value which make investors nervous. Stablecoins, as the name suggests, are designed to remain stable.

Most stablecoins are tightly tied to a traditional fiat currency, like the US dollar, or a commodity like gold. Investors buy them to store money and facilitate transactions within the cryptocurrency infrastructure. They are also used for other types of financial exchange, such as lending, borrowing, or sending payments overseas with less friction than going through a traditional bank.

Their supposed stability has turned these once obscure tokens into the backbone of the crypto ecosystem. The collective market value of all stablecoins rose to $180 billion in March this year, according to the Federal Reserve.

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

Some stablecoins have a 1-to-1 connection with real assets, like US Treasuries. Some are linked to bonds, the value of which can fluctuate.

But it was the stablecoin’s finicky cousin, the “algorithmic stablecoin,” that sparked panic among investors this week. And while they seem similar, the algorithmic variety is, functionally, another beast entirely.

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The unstable piece?

Most stablecoins are backed by real collateral such as dollars or cash equivalents. But algorithmic stablecoins are not necessarily backed by a real external asset, relying on complex financial engineering to keep their value stable. And when they fall, they tend to fall hard – industry watchers call it a “death spiral.”

Algorithmic coins are “just a fancy way of saying, ‘We’re going to say it’s worth a dollar because it’s backed by another asset that we’re also creating out of thin air,'” says Charles Cascarilla, managing director and co – founder of Paxos, a blockchain infrastructure company.

In the case of TerraUSD, that other “out of nowhere” asset is the Luna cryptocurrency.

This is how it works:

  • An investor can, in theory, exchange one Terra for one dollar of Luna, its sister token whose price is not fixed.
  • Traders who engage in a process called arbitrage are able to make a quick profit by exploiting fluctuations in either asset, creating an incentive to hold Terra’s value steady at $1. For example, if Terra falls below $1, arbitrage traders rush to buy Terra low and trade it for $1 of Luna.
  • This ultimately creates an ecosystem where traders trade Lunas and Terras to keep the value of Terra at $1.

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The belief

The problem is that the whole ecosystem relies on traders believe Luna has value. Once investors lose faith in the system, all bets are off.

“Any morning people might wake up and say, ‘Wait a minute, you just made this all up, it’s worthless’ and decide to throw away their Lunas and Terras,” the Bloomberg columnist wrote, Matt Levin.

Apparently that’s what happened this week. The wheels started to come off over the weekend as investors started pulling out of Terra and Luna.

“It’s exactly the ‘death spiral’ that a lot of people predicted,” said Henry Elder, head of decentralized assets at Wave Financial, a digital asset manager.

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What happens next?

Stablecoin advocates warn that now is not the time to throw the baby out with the bathwater, noting that stablecoins backed by currencies like Tether and USDCoin have held steady during Terra’s collapse this week.

But on Thursday, mounting pressure rocked Tether, the world’s largest stablecoin with a market capitalization of $80 billion. Tether fell as low as 96 cents early Thursday, according to CoinMarketCap. The second-largest stablecoin, USDCoin, meanwhile, held steady at $1.

Chief Technology Officer of Tether sought to reassure investors Thursday, Tweeter that the parent company of the coin is still honoring redemptions at the $1 level “without breaking a sweat”.

Do Kwon, the CEO of Terraform Labs, tweeted on Wednesday that recovery efforts were underway, encouraging investors to “stay strong.” Backers appeared to be struggling to win investor support for the stimulus package on Thursday, Bloomberg reported, citing people familiar with the matter.

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Investors and regulators on the alert

Bitcoin, the world’s largest cryptocurrency, also suffered from the sour crypto mood.

Early Thursday, the crypto was trading at around $28,000, down more than 12% over 24 hours. (Bitcoin, like other cryptocurrencies, trades 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 watching, fearing the situation could create unpleasant and unpredictable aftershocks for investors of all stripes.

Testifying before the Senate earlier this week, Yellen commented on Terra’s decline, saying it “just illustrates that it’s a rapidly growing product and there are risks to financial stability.”

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

Crypto evangelists tend to view meltdowns like Terra’s as an unfortunate loss, but one that ultimately helps bolster the credibility of the underlying blockchain technology.

“I think the process of winnowing good ideas and bad ideas ultimately strengthens the ecosystem,” says Cascarilla de Paxos. “The economy is totally going at internet speed, but the financial system is still running at mail speed… Unfortunately, there are those moments of creative destruction that end up being one of the best means sort of reducing things to what people can really get behind.

—Julia Horowitz of CNN Business contributed reporting.

The-CNN-Wire™ & © 2022 Cable News Network, Inc., a WarnerMedia company. All rights reserved.

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