Stablecoin Meltdown: What Happened?

It’s been a blistering spring for the 300-million community of crypto investors. Bitcoin (BTC) has gone underneath $31,000, the popular stablecoin UST has plummeted much lower than its peg of $1, and its sister token Luna has sunk to a sad number of three decimal places against the U.S Dollar.

So, how’s everyone dealing with the current crypto breakdown?

Not my first rodeo, you’ll hear veteran HODLers say and try to keep their cool. Experts in the business field, on the other hand, are somewhat frustrated but hardly surprised — they predicted this crisis as a direct side effect of the unfavorable macroeconomic environment. But new investors might get discouraged thinking that Bitcoin’s heyday is over.

However, Bitcoin and its fellow crypto coins have demonstrated a Phoenix-like power throughout the years and have risen from their ashes time and time again, so this time it shouldn’t be any different, right?

Well, before jumping to any conclusion on the next crypto pitch — upwards or downwards, let’s go through the main reasons for this crisis in the global crypto market. Starting with stablecoins!

What Are Stablecoins?

Stablecoins are a separate class of digital assets that came along with a clearly defined purpose to soften the volatility in the crypto trading arena.

Similar to Bitcoin and other cryptocurrencies, stablecoins reside on the blockchain, but their supply isn’t controlled by any consensus mechanism. Instead, stablecoins work with a centralized company in the back, which doesn’t limit their supply but must sustain the production of each newly-minted coin by adding another asset to a specific fund reserve. The backup asset is usually a fiat currency, such as USD, but it can also be a commodity like gold or even another cryptocurrency

For that reason, we say that stablecoins are pegged to a single unit of another asset in a 1:1 ratio. So, the stablecoins’ price can’t explode and plummet as a result of the public mood. If they’re tethered to USD, their market value is 1 USD sharp or an amount around 1 USD.

Being a border case between fiat and crypto, stablecoins are raising governments’ scrutiny since the company running the stablecoin doesn’t usually let the backup fund rest in a bank account but invests it in other dynamic businesses for profit. Technically, this isn’t illegal, but it means that the company doesn’t maintain the necessary liquidity at all times, and hence, stablecoins have no value at all.

However, they have turned out to be the moving force in the crypto trading industry. Stablecoins have made the crypto scene a more flexible ecosystem, which wasn’t possible with fiat currencies because of the slow and expensive crypto-to-fiat transfers.

For example, the most popular stablecoin, Tether (USDT), is the third crypto by market cap and, believe it or not, the first in trading volume according to CoinMarketCap. However, remember that stablecoins aren’t a suitable investment material for HODLers and crypto-saving accounts since price booms aren’t on their agenda.

Now let’s find out how Luna and UST made a plot twist in this stablecoin story.

The Collapse of Terra (Luna) and TerraUSD (UST)

The volatility of crypto-assets hasn’t been uncommon in the short but eventful crypto history. However, much of 2022 had been oddly quiet for the cryptocurrency market, and it stayed like that until one of the best-ranked stablecoins lost its stability.

Out of the 100 circulating stablecoins, very few use algorithms as a backup instead of a tangible asset. Run by Terraform Labs company, UST is one of these algorithmic stablecoins that utilizes complex code combinations and LUNA to maintain continuous stability.

More precisely, every time a UST token is generated, LUNA tokens of the amount of $1 are burnt and vice versa. This allowed UST holders to sell their coins in exchange for $1 of Luna, with a slight profit every time there was a threat for UST deppeging — going below the $1 standard.

Since its launch in 2019, Luna has been a well-performing token with a steady rise and high rank on all relevant crypto charts. However, once the bearish climate started discouraging investors on a global scale, they started massively selling out their UST coins, which caused lethal inflation and devaluation of Luna. For illustration, at the beginning of 2022, there were 345 million units of existing LUNA tokens, and this number drastically jumped to 3.47 billion on May 12, only to hit an unbelievable 6.5 trillion units of Luna the very next day.

Ironically, LFG (Luna Foundation Guard), the company responsible for adding collateral supply to maintain the UST peg, presented a recovery package whereby the foundation purchased a huge amount of bitcoins to be added to the treasury reserve, thus keeping UST alive. However,  this was only a short-term plan executed at the wrong time — in May 2022, BTC wasn’t doing well on global markets, which led to additional negative outcomes for LFG.

Eventually, major cryptocurrencies like Bitcoin and Ethereum are bouncing back, leaving Luna as collateral damage in this market mess. Three days after the black May 12 (1 BTC = 28,000 USD), Bitcoin’s price rose by nearly 10%, while Luna ended up delisted from all dominant crypto exchanges.

Macroeconomic Factors

In the spring of 2022, the world faced interest rate rambles, rising inflation, and political instability due to the Russian-Ukraine war. This series of events triggered critical alerts among some investors that inflation in the post-pandemic era could impact global business development, including virtual assets.

Interestingly, Bitcoin was designed to serve as a hedge against inflation on the market, but figures show that it didn’t stay immune to the painful shafts happening right now. From a psychological point of view, the general atmosphere tends to discourage investors from expanding their virtual portfolios amid insatiable times.

However, experts didn’t change their estimations for Bitcoin’s future because of the momentary crisis. For example, Caleb Franzen, a market analyst for the world-renowned Cubic Analytics, asserts that Bitcoin will keep serving as an inflationary hedge in the years to come, despite the very close correlation between crypto and the traditional stock market.

The Bottom Line

There is no straightforward answer to explain the current crypto plunge — all listed factors contribute to building the public image as a driving force in establishing the prices of the circulating cryptocurrencies. The latest LUNA/UST debacle shows that we need a tighter framework for regulating stablecoins. Otherwise, they can easily take the Ponzi route without regular checkups and hence, negatively impact the upward growth of established cryptocurrencies like Bitcoin, Ethereum, Litecoin (LTC), ZCash (ZEC), and Stellar (XML).

As for macroeconomic factors, we can’t control them, but we can definitely use them to our advantage. Bearish spells are the optimal time for buying stocks or cryptos as attractive financial instruments at a low price.

For all other crypto-related questions, you can reach out directly to our Coin IRA team. They may be able to offer you some insight on current market conditions so you can decide what your best options are based on your risk tolerance and personal financial goals.

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