The Impact of Stablecoin Collapses on the Digital Asset Industry

Terracoin continues to plummet following its collapse. Stablecoins, a term used to describe virtual coins whose prices are supposed to be pegged to a fiat currency or cryptocurrency, have continued to cause destruction because there is a bank run every time the peg faces downward pressure. A bank run is when numerous investors withdraw their funds from the exchange due to their concerns over its solvency, which would result in them losing money.

The Impact of Stablecoin Collapses on the Digital Asset Industry

In crypto trading, there are not many regulations that offer standards for creating new stablecoins and ensuring that stablecoins will survive weakening economic conditions. Crypto exchanges are currently feeling increased competition and are coming out with new tokens to keep up in the industry. These new tokens are not regulated by a central body, like a federal government or central bank, which makes them more likely to cause problems. Investors can trade these tokens on exchanges through crypto trading apps. Through iterations of bank runs such as the Terracoin collapse on May 11th, it has been brought to creators’ and investors’ attention that more protocols are needed over stablecoins. The primary standard should be that stablecoins require backup by multiple assets to prevent bank runs including US treasuries, fiat currency, and bitcoin.

What Happened in Crypto Trading that Led to the Collapse of Terracoin

The Federal Reserve made a statement on May 9th about how stable coins had increased liquidity risks and were vulnerable to bank runs. On the same day, Terracoin lost roughly 30% of its value as investors feared low liquidity. As a result of Terracoin’s collapse, Luna, a popular cryptocurrency token that is Terra’s native, had a 40 billion dollar collapse last week. Other decentralized stablecoins fell that week as well. The lack of standards created to monitor stablecoins has led to widespread problems for the asset.

How Does a Stablecoin Work?

Stablecoins, which are a type of cryptocurrency, aim to peg to another fiat currency, commodity, or cryptocurrency in the market. Stablecoins maintain price stability by having collateral in other assets such as US treasuries, the US dollar, or other cryptocurrencies like bitcoin. 

Conventional cryptocurrencies such as bitcoin tend to suffer greater price volatility than stablecoins. The huge fluctuations in price can cause huge intraday swings and can be detrimental to investors over the long term. Cryptocurrencies can entirely lose their purchasing power when their prices plunge and lose all of their value. Stablecoins can help to solve the volatility problem of cryptocurrencies by aiming to retain their purchasing power and value.

Types of Stablecoins

Investors should be aware of the several types of stablecoins that exist in the market. Fiat-collateralized stablecoins use a fiat currency as collateral to back up their value. Other stablecoins can use commodities or precious metals like silver and gold. There are also crypto-collateralized stablecoins that gain their value through the backing of other cryptocurrencies. Algorithmic stablecoins, like TerraUSD, do not maintain a reserve asset to store their value, and the value of a stablecoin is maintained through control of an algorithm. 

What Does the Future Look Like for Stablecoins?

Economists state that it will be challenging for algorithmic stablecoins, which are reliant on collateralized prices, to increase their value when market conditions are getting worse. Some people are highly skeptical of the future of stablecoins. Unlike centralized stablecoins that simply need time to recover from a collapse, algorithmic stablecoins require outside capital or the use of another algorithms to reestablish themselves. Although Terracoin already had significant collateral before its decline, including US treasuries, bitcoin, and LUNA, Terra needed an even more diverse array of collateral to prevent a collapse.

A primary crypto trading lesson gained from this situation is that it is highly important to back up a stablecoin with US treasury and fiat currency collateral. This protocol needed to be put in place, but it could only be figured out by learning about how stablecoins behave. Additionally, the International Organization of Securities Commissions (IOSCO) stated in October 2021 that stablecoins must be regulated as financial market infrastructure with payment systems and clearinghouses.

The Lack of Regulation for Crypto Exchanges

The decentralized nature of cryptocurrency is appealing to investors because cryptocurrencies are not regulated by the federal government or any central body, so there is no third party regulating transactions. The decentralized aspect of crypto also makes it easier and faster for investors to transfer funds without a bank or credit card company on a crypto trading app. Decentralization also prevents a single-point failure that could result in the collapse of the system.

However, the lack of regulation in the industry can cause more harm than good. The price volatility of the crypto market can cause investors to suffer enormous losses. Cryptocurrency is also more vulnerable to hackers who can break into an investor’s crypto wallet and conduct transactions once they get access to the key. The lack of regulation has made it so there are no standards that exchanges must abide by when they generate new tokens. There are also no protocols for how to adequately back up stablecoins to mitigate losses caused by bank runs.

The Bottom Line

The goal of stablecoins is to peg the value of a different asset, like the US dollar. However, algorithmic stable coins can run into trouble because they do not hold reserve assets like crypto or fiat-collateralized stablecoins. This situation can become a problem when a stablecoin loses its value and has no assets to back it up. The price of Terracoin declined over 60% on May 11th which made it so it no longer was pegging to the US dollar. This instance also led to the decline of its sister coin, LUNA, which fell over 80% throughout one night. 
There is a need for greater regulation surrounding stablecoins to prevent the collapse of algorithmic stablecoins in the future. Protocols need to be established such as ensuring that algorithmic stablecoins have a diverse and substantial amount of collateral to mitigate future collapses. The future may hold for stablecoins to be regulated by a financial market infrastructure with clearinghouses and payment systems.

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