Stablecoins are struggling to survive the crypto crash

It has been a crushing few days for the Terra project, in a week that has not spared the cryptocurrency as a whole.

Over the past few days, the TerraUSD (UST) stablecoin, which is meant to hold a peg to the dollar, has broken sharply off the $1 mark and dropped to a low of less than 30 cents on May 10. In the latest update to the saga, the beleaguered project put its entire blockchain detained for about two hours on Thursday, freezing user funds until the blockchain resumed.

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It’s a harsh move, particularly given cryptocurrencies’ emphasis on decentralization. “We’ve seen hard forks before, but this is the first time we’ve seen such a large decentralized blockchain system decide to stop everything,” said Ronghui Gu, CEO and founder of blockchain security firm CertiK.

The chaos has been fueled by a strong slide that has seen $200 billion in value wiped out in a single day. bitcoin only dropped below $25,000 on the morning of May 12, a price not seen since December 2020 and less than half of its peak in November 2021. Other cryptocurrencies have faced a few days of similar punishment, with Ethereum having lost about 20 percent of its value in just 24 hours.

Terra’s troubles began on May 9 when the price of the UST stablecoin began to drop sharply. Due to the way algorithmic stablecoins operate, this caused a large increase in the supply of the corresponding Luna cryptocurrency token, which trades against UST to balance the price.

Previously, adding Luna tokens to circulation or removing them was enough to maintain a constant price for UST. But the size of the price drop and the corresponding amount of Luna minted: supply more than tripled within days, it sent the two linked cryptocurrencies into a “death spiral” from which neither has been able to recover.

Currently, UST is trading at around 40 cents instead of $1; and the value of Luna has almost completely disappeared, dropping from $100 to around 1 cent.

Terra’s nightmarish week clearly shows that stablecoins, which in theory should maintain a fixed price, can actually be highly affected by larger movements in the cryptocurrency market, and affect those movements in turn.

Terra is not the only stablecoin facing problems in the wake of the cryptocurrency downturn. Tether’s USDT stablecoin, the largest by circulation, sank well below its dollar parity at trade at 95 cents on some exchanges on Thursday morning, although the price has since recovered. The moves were significant enough that Treasury Secretary Janet Yellen stepped in to reassure the US House Committee on Financial Services that the events did not represent a significant risk to the financial markets as a whole.

Still, the sudden drop is a reminder that the economics behind most stablecoins are still highly experimental. “There are fiat-backed stablecoins, but people feel this is too simple: in the web3 and blockchain world they want to come up with big, new ideas and innovations,” Gu said. “That is why there is so much research on whether it is possible to use algorithms to generate a stablecoin, but so far there are no completely convincing solutions.”

Terra’s future is uncertain, but the sheer volume of unredeemed Terra Coins presents a major problem for the project. As more coin holders try to cash out, they are likely to further devalue the Luna token supply, creating than BloombergMatt Levine described as “a death spiral.”

But Gu remains cautiously optimistic about the broader future of stablecoins. “The crash shows that people have overestimated what can be done with blockchain and web3 in a short period of time,” he says, “but they still underestimate what can be done in five or ten years.”