Cryptocurrencies have long been considered a hedge against inflation and a better alternative to fiat currencies that are susceptible to devaluation concerns. Most cryptocurrencies have significantly underperformed benchmark stock market indices due to liquidity pressures brought about by the tightening of monetary policy by leading central banks such as the U.S. Federal Reserve.
Aimed at slowing down record inflation numbers being reported about the world’s largest economy, the quantitative tightening has caused both stock and cryptocurrency prices to correct significantly from their peaks and is eerily reminiscent of the bear cycle in 2017.
Are Stablecoins Really Stable?
While stablecoins such as Tether USDT/USD and USD Coin USDC/USD have recovered after being getting depegged from the U.S. dollar, the Terra UST/USD crash has quashed the belief that stablecoins are stable after having wiped off billions of dollars of investor capital.
Even though USDT and USDC contribute to nearly 80% of the stablecoin market, the panic caused by the UST crash resulted in USDT losing more than $10 billion in market cap while USDC benefitted massively with its market share rising from 27% to 34% in the aftermath.
Issued on a 1:1 basis with collateralized U.S. dollar funding, these tokens have now stabilized near the $1 mark as their issuers took steps to secure additional collateral to compensate for any further selling pressure from jittery investors.
Overcollateralized Stablecoins Susceptible to Liquidity Risks
On the other hand, overcollateralized stablecoins such as Dai DAI/USD, Magic Internet Money MIM/USD and Liquidity USD LUSD/USD, which use non-stablecoin cryptocurrencies like Bitcoin BTC/USD and Ethereum ETH/USD as collateral, remain susceptible to liquidity risks brought upon by falling prices for these leading cryptocurrencies.
Since these overcollateralized stablecoins use BTC, ETH or other derived assets as collateral, the additional margin needed to retain the U.S. 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 mechanism of the UST crash is a bit more complex, it is evidently clear that stablecoins have a long way to go before they can win back investors’ trust.
Some stablecoins like USDD USDD/USD, 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% to investors staking the stablecoin.
However, a large part of this strength is the fact that retail investors can only trade the USDD stablecoin on the secondary market while all other activities such as token issuance, burning and management are attributed to the TRON DAO Reserve’s approved whitelist rather than the underlying algorithm.
Innovative Ways to Maintain the USD Peg
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 Share FXS/USD as a value accrual and governance token that remains volatile by design.
Offering better stability than fully algorithmic stablecoins such as UST or TerraClassicUSD USTC/USD in its new avatar, FRAX is an example of how crypto entrepreneurs are experimenting with innovative ways to maintain the U.S. dollar peg with more stability.
Stablecoins Fostering DeFi Expansion
Although often chosen based on 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 behind by the UST crash.
While the jury is still out on how the entire basket of stablecoins navigates through the current crypto bear period, further price corrections could severely undermine the very foundation on which these virtual assets are created.
Governments Contemplating Regulations
Recognizing the need for immediate regulation to avoid a repeat of the UST debacle, financial regulators in markets in the U.S. and U.K. are already contemplating legislation amendments to ensure that existing legal frameworks can contain risks associated with the failure of such 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 dependent world.
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