Understanding how stablecoins have fared in the crypto bear market

Representative Image [Image: Shutterstock]

Long considered a hedge against inflation and a better alternative to fiat currencies that are susceptible to devaluation, most cryptocurrencies have significantly underperformed benchmark stock market indices.

The reason: Liquidity pressures brought on by the tightening of monetary policy by central banks led by the United States Federal Reserve (Fed) and including the Reserve Bank of India (RBI).

Fiat currencies are money issued by central banks that’s not backed by a commodity like gold.

Aimed at arresting record inflation in the world’s largest economy, the quantitative tightening has caused both stock and cryptocurrency prices to correct significantly from their peaks in a phenomenon eerily reminiscent of the bear market cycle in 2017.

While stablecoins like Tether (USDT) and USD Coin (USDC) have recovered smartly after being getting de-pegged from the US dollar, the Terra (UST) crash has quashed the belief that stablecoins are stable after having wiped off billions of dollars of investor capital.

Created as a better alternative to other volatile cryptos like Bitcoin or Ether, stablecoins have their values tied to other fiat or crypto currencies, commodities or even financial instruments and offer a far less volatile option for transacting in the blockchain ecosystem.

Although USDT and USDC contribute nearly 80 percent of the stablecoin market, the panic caused by the UST crash resulted in USDT losing over $10 billion in market cap. USDC benefitted massively with its market share rising from 27 percent to 34 percent in the aftermath.

Issued on a 1:1 basis with collateralised US dollar funding, these tokens have now stabilised at near the $1 mark as their issuers took steps to secure additional collateral to compensate for any more selling pressure by jittery investors.

Liquidity risks

On the other hand, over-collateralised stablecoins such as Dai (DAI), Magic Internet Money (MIM), and Liquidity (LUSD), which use non-stablecoin cryptocurrencies like Bitcoin (BTC) and Ethereum (ETH) as collateral, remain susceptible to liquidity risks brought on by falling prices for these leading cryptocurrencies.

Since these over-collateralised stablecoins use BTC, ETH or other derived assets as collateral, the additional margin needed to retain the US dollar peg has the propensity to exert further downward pressure on the underlying cryptocurrency.

This eventually can set about a domino effect, something that was amply demonstrated by the UST crash.

While the exact manner of the UST crash is a bit more complex, it is evident that stablecoins have a long way to go before they can win back investors’ trust.

Some stablecoins like USDD, issued by Tron and whose primary activities are managed by the TRON DAO Reserve, have displayed better stability while also delivering an interest rate of 30 percent to investors staking the stablecoin.

However, a large part of this strength is down to the fact that retail investors can only trade the USDD stablecoin on the secondary market while all other activities like token issuance and management are attributed to the TRON DAO Reserve’s approved white list rather than the underlying algorithm.

Another approach can be seen with the FRAX stablecoin, touted as the world’s first fractional-algorithmic stablecoin by its creators, that uses USDC as collateral and Frax shares (FXS) as a value accrual and governance token that remains volatile by design.

Innovation to maintain dollar peg

Offering better stability than a fully algorithmic stablecoin like UST, or Terra Classic (USTC) in its new avatar, FRAX is an example of how crypto entrepreneurs are experimenting with innovative ways to maintain the US dollar peg with more stability.

Although often chosen on the basis of the profitability on offer by virtue of incredible interest rates, stablecoins are increasingly fostering the expansion of the decentralized finance (DeFi) space and will continue to attract more protocols that are vying to take advantage of the vacuum left by the UST crash.

While the jury is still out on how the entire basket of stablecoins navigates the current crypto bear market, further price corrections could severely undermine the very foundation on which these virtual assets are created.

Recognizing the need for immediate regulation to avoid a repeat of the UST debacle, financial regulators in markets such as the United States and United Kingdom are already contemplating legislative amendments to ensure that existing legal frameworks can contain risks associated with the failure of firms issuing stablecoins.

Whether issuers would have to secure their stablecoins with tangible assets instead of other stablecoins or cryptocurrencies in the future is still a matter of speculation.

Both innovation and regulation will be needed to ensure stablecoins can survive the test of time and prove their worth in a Web3 world.