What are the different types of stablecoins, which ones to avoid and what to look for in your due diligence.
Stablecoins allow users to “hedge” against the changing value of a crypto asset, providing a better value than traditional exchanges and other crypto alternatives like bitcoin or ethereum. In contrast to bitcoin’s price swings, stablecoins are pegged to some stable asset, often the U.S. dollar.
This category of crypto-assets has been described as a “way to make bitcoin, and other digital currencies, more usable for day-to-day purchases”.
Not so stable?
Stablecoins have been in the news lately after a large stablecoin called Terra wiped out and lost its link with the value of the dollar, dragging it's sister Luna with it.
Many retail investors assume that stablecoins are backed by their real-world asset, for example that Terra was backed by the dollar itself. And this is certainly the case with true stablecoins, like Thether Gold, USD Coin, Binance USD and many others.
But some stablecoins aren't backed by those assets and are synthetically held up by algorithms, which is why they're called 'algorithmic stablecoins'.
Terra was an algorithmic stablecoin, using a complicated and brittle supply and demand algorithm to maintain a consistent price versus the dollar. It was never backed by the US dollar, it was 'pegged' to it's value.
When TerraUSD fell below 1 dollar, new Luna tokens would be minted, and since Luna had some (high fluctuating) value in dollars, this worked to increase the price of TerraUSD back to 1 dollar.
In May 2022, UST's peg to the dollar slipped and the algorithm increased printing in Luna to correct this but the printing resulted in further loss of confidence and Luna was dumped in massive amounts, which led to further pressure on the price and the situation spiralled out of control.
The number of Luna's in circulation went from about 350 million to 6 trillion after the crash and it is widely considered now impossible for the peg to ever recover.
In other words, the stability of an algorithmic stablecoin to its real asset is at the mercy of the markets and is far from guaranteed. Understand what you are getting into, and consider whether the stablecoin you are investing in, is actually backed by the asset it's supposed to be pegged to.