On Wednesday, the cryptocurrency community saw TerraUSD (CRYPTO: UST) the native algorithmic stablecoin of the Terra (CRYPTO: LUNA) protocol lose its peg while bringing LUNA down with it.
Many are now wondering if something similar could happen with traditional stablecoins such as USD Coin (CRYPTO: USDC), but the same scenario cannot occur with such systems. Here's why.
What Happened: On Wednesday, TerraUSD saw its price fall away from its peg to a low of under 30 cents per token while Terra lost well over 97% of its value when falling from $33.20 down to a low of $0.8755. Still, the same mechanism that hurt both Terra and TerraUSD cannot hurt traditional stablecoins such as USD Coin.
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TerraUSD is an algorithmic stablecoin not backed by U.S. dollars but highly volatile Terra tokens, while attempting to maintain the token's value stable at $1 (or "pegged") thanks to crypto incentives.
Whenever UST trades under $1, it creates an incentive to buy as much UST as possible to then destroy it and mint $1 worth of Terra per each token instead, which can be then sold at a profit.
When UST trades over $1, it creates an incentive to buy Terra and mint as much UST as possible to sell it at a profit since minting new tokens still cost $1 in Terra, which increases TerraUSD's supply to lower the price again.
As we explained in Wednesday's analysis, what presumably occurred Thursday is a consequence of Saturday's initial fall of TerraUSD's value under $1, which was caused by the sudden sale of $285 million of UST on decentralized finance (DeFi) protocol. This resulted in a prolonged loss of confidence in its capacity to maintain its value stable.
This also caused sustained selling pressure on Terra, which initially lost about 20% of its value, but UST has been under its $1 price target ever since Monday despite regaining it soon after the initial incident.
The sustained selling pressure, through new token minting, also resulted in Terra's sudden supply inflation. This, paired with the use of UST as a stablecoin becoming unpractical and dampening demand for the stablecoin, initiated a runaway reaction.
This reaction resulted in billions of dollars evaporating from Terra's and TerraUSD's market caps in mere hours, as Terra's supply increased by over 9.5% in under 24 hours.
The Difference With Stablecoins: A stablecoin such as USD Coin — while not without its fair share of controversy — is a much simpler system not backed by cryptocurrencies and instead uses centralized vaults of traditional assets that are expected to be much more stable and do not rely on complex arbitrage incentives to maintain value.
As reported in late August 2021, after a scandal over USDC being backed by about 61% of its tokens, it is now backed by “cash and cash equivalents" with the rest being backed by more risky traditional assets.
USD Coin operators Circle and Coinbase Global Inc. (NASDAQ:COIN) promised to switch to a conservative investment approach in September 2021 — using only "cash and short-duration US government treasuries."
USDC is not without its risk and does not have a completely clean record — especially considering that until the aforementioned scandal, Circle claimed that every USDC was backed by $1 in a bank account — but the risks involved are very different.
Unlike TerraUSD, USD Coin has centralized reserves. Investors have to trust the auditing third parties when they claim the asset is backed and by what, instead of being able to check the balance of a smart contract to see for themselves.
On the other hand, USD Coin's backing assets are much more likely to keep their value stable and ensure the stablecoin's value is stable in the long run.
Lastly, USD Coin is mostly a symbolic token with little to no smarts, whereas TerraUSD is a complex system, which implies that much more can fail. It may be possible for its — decentralized — backing assets to be stolen in a hack.
Benzinga's Take: As nearly always with blockchain technology, the safety of stablecoin systems is not simple and cannot be simply explained as one approach being better than the other.
Algorithmic stablecoins attempt trustlessness, but creating such complex systems that are reliable despite the high incentive to hack them results in a significantly higher likelihood of something going wrong.
