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The upheaval in the stablecoin market

Khairani Afifi Noordin
Khairani Afifi Noordin8/18/2022 08:18 PM GMT+08  • 6 min read
The upheaval in the stablecoin market
The stablecoin market was rattled recently by a series of events surrounding the Terra Luna collapse. Photo: Shutterstock
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In 2019, Facebook — now Meta Platforms — announced project “Libra”, which was intended to be a universal currency tied to a basket of sovereign currencies such as the US dollar and the euro. Unsurprisingly, regulators and central banks were not too enamoured by the idea of a private company trying to muscle into what has been their much-cherished sovereignty of issuing a currency. A growing list of project partners began to get cold feet. As regulatory challenges mounted across multiple jurisdictions, the project, which was renamed “Diem”, ultimately met its demise early this year.

While project Diem never officially launched, many other stablecoins — or digital assets backed by a reserve of real assets such as fiat money — met the market and thrived over the years. Tether (USDT), for example, is the largest stablecoin in terms of market capitalisation, which stood at US$67 billion ($92 billion) as at Aug 18, followed by USDC at US$53 billion and Binance USD at US$18.2 billion.

Designed to solve the issue of volatility that may have held back the potential adoption of cryptocurrencies for everyday financial purposes, stablecoins provide less volatility for investors and traders compared with other types of cryptocurrencies as they are typically pegged to price-stable assets.

Recently, however, the stablecoin market was rattled by a series of events surrounding the Terra Luna collapse, which had caused negative sentiments around the digital asset.

Feroze Medora, director of trading at Gemini Asia Pacific, explains that unlike “traditional” stablecoins which are backed by fiat money, terraUSD (UST) uses an algorithm to maintain a consistent value. These algorithms typically link two coins and adjust the prices depending on the supply and demand of investors.

The first form of algorithmic stablecoin was actually introduced by MakerDAO back in 2016, says Medora. Its stablecoin, Dai, is the world’s first crypto-collateralised and decentralised stablecoin, whose value is soft pegged to the US dollar. Instead of fiat, the collateralised assets backing Dai are various other cryptocurrencies and are held within smart contracts rather than institutions.

See also: Bitcoin becomes best-performing asset class in first quarter after gaining 70%

Dai is often compared with UST as both stablecoins operate under decentralised finance protocols. While Dai can be minted by pledging various other crypto assets as collateral, UST is minted by burning its sister token Luna, bringing the price back into equilibrium.

As 1 UST was defined as being equal to US$1 worth of Luna, the amount of Luna handed over in a swap for UST would vary. This proved to be problematic when the cryptocurrency market went bearish, says Medora. “When you have a lot of dollars in issuance and the assets that back those dollars are dropping — which is unfortunately what happened in Q1 this year — naturally, investors would try to take their money out,” he explains.

“Nobody wants to be last, so it creates a race. One person wants to get his money out. The second guy sees that and also takes his money out, creating this domino effect similar to the Northern Rock bank run which occurred in 2007,” says Medora, referring to the first UK bank to fail in 150 years because of a run.

See also: Singaporeans still actively investing in crypto despite a hit in confidence: IRCI

When UST began to drop below US$1, Luna also started to sell off, resulting in a vicious cycle that eventually caused Luna to drop from its high of US$125.85 apiece on March 31 to less than 1 cent just two months later. UST, meanwhile, is now just worth 2.5 US cents apiece.

Medora says it took a while for the impact of the UST and Luna crash to reach the broader market. One notable casualty was Three Arrows Capital (3AC), a Singapore-based crypto hedge fund which was ordered to liquidate on June 27 after it had borrowed billions of dollars to fund its trading and faced US$3.5 billion in creditors’ claims.

In mid-June, 3AC had confirmed that it suffered heavy losses including its US$200 million investment in Luna tokens as part of a US$1 billion raise by the Luna Foundation Guard in February.

USTC 1-year price history. Chart: CoinGecko

Stablecoin best practices

Despite the bad press that stablecoins have gotten following the crash of UST, Medora says that it is not likely that investors would ditch the tokens anytime soon. Its utility as a medium of exchange bridging the gap between fiat and cryptocurrency is very attractive from investors’ point of view, especially to those who are trading on multiple exchanges.

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Like the name suggests, stablecoins are also less volatile than other coins, making it a great store of value, says Medora. “Sometimes, stablecoins that are meant to be pegged to the US dollar can be trading at a tiny premium, perhaps at US$1.001 — this is because the general sentiment that everyone is exiting the risky assets and buying stablecoins,” he notes.

“People are risk-averse. They do not want the risk of certain cryptocurrencies swinging 10% per day, for example. They’re happy to sell their tokens, store it in the form of stablecoins which is also a cryptocurrency, and then easily switch back to Bitcoin or other cryptocurrencies when they want to. They are willing to pay the premium to avoid this volatility,” he adds.

As the number of stablecoins issuers grows, Medora says it is important for investors to do their own due diligence in assessing whether a certain stablecoin is worth holding onto. He advises: “Number one, they should look at the mechanism; what are the assets backed by? How do they work? Number two — and this is where regulation really helps — how are the issuers regulated? What are the governance structures in place around the company and their operational controls?”

Gemini Asia Pacific director of trading Feroze Medora. Photo: Gemini

Gemini, for example, began issuing its stablecoin Gemini Dollars (GUSD) in 2018, benefiting from the direct supervision and regulatory oversight of the New York State Department of Financial Services. Each GUSD corresponds to a US dollar that is held by Gemini in accounts at US Federal Deposit Insurance Corp-insured banks or money market funds holding short-term US treasury bonds and maintained at a custodian.

GUSD is also audited on a monthly basis by BPM, a private and independent accounting firm thwat ensures there is parity between the amount of US dollar in reserve and the amount of GUSD in circulation, explains Medora.

“Also, in general, investors should not get swept up with a bullish market sentiment such as the one that prevailed last year. Many perhaps were not answering the question of what happens if certain tokens halves in value, which what we have seen happened this year,” says Medora.

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