Stablecoins Used to be Immune to Stress — Now they Must Withstand Volatility

Of all the instruments in crypto, stablecoins may have the most utility. 

These assets, often pegged to the U.S. dollar, provide the benefits of holding value on-chain without the drawbacks of volatility. Users can tap them for a number of functions throughout DeFi — to borrow, lend, and to provide liquidity and trade out of crashing assets. And, of course, they can be used for that ever-durable use case — paying people.

Tremendous Stress

Even so, stablecoins came under tremendous stress in 2022 after one of the most widely held — Terra’s UST — slipped its peg to the dollar and precipitated a crash that vaporized $19B in market value and triggered the collapse of numerous other projects, including Three Arrows Capital, and in part, FTX. 

The problem was a fundamental breakdown in its exchange mechanism. UST could be redeemed for $1 of LUNA, Terra’s native token. But when UST’s market capitalization surpassed LUNA’s in the spring, it became clear that the stablecoin wasn’t fully backed and the mechanism was flawed.

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If Terra had maintained reserves of U.S. dollars to back UST, there would have been no problem. As soon as investors saw that LUNA could not support the stablecoin, it was finished. 

Critics pounced as investors nervously eyed other stablecoins such as Tether’s USDT, Near’s USN, and Huobi’s HUSD (the latter two would collapse). U.S. Secretary of the Treasury Janet Yellen called for regulations of stablecoins in May. “[Stablecoins] run risks which could threaten financial stability,” she said in a Senate Banking Committee Hearing. 

Higher Percentages

So what comes next for stablecoins? 

The pegged-assets still stand to help crypto turn the corner and become a more mature financial system. And they don’t even have to be pegged to a dollar — Vitalik Buterin, Ethereum’s co-founder suggested a stable asset designed to track the consumer price index (CPI), in his recent article on what excites him in the Ethereum ecosystem. 

Stablecoins have continually accounted for higher percentages of crypto transactions, according to a chart provided by Chainalysis, the blockchain intelligence firm.

In 2022, it was a mixed year for stablecoins — of the top five pegged-assets, two, USDC and BUSD, ended up with higher supply than they started the year with, and three, DAI, USDT, and FRAX, did not, according to The Defiant Terminal. 

The year closes with a stablecoin market capital of just over $140B in aggregate, according to CoinGecko. This comes despite rising interest rates in the traditional financial world which act as an ever strengthening magnet for investors seeking a stable yield.

Peg

Sam Kazemian, founder of the fifth largest stablecoin protocol, Frax Finance, sees the current environment as a time to batten down the hatches. 

“We have no idea where the market is headed,” he told The Defiant in November. “So we have to be prepared for truly the worst and make sure our peg, our products, and our protocol excels in the most vicious of environments.”