Unstable Stablecoins: Can Stablecoins Crash?

Yes, stablecoins can crash. While they are designed to be a less volatile form of cryptocurrency, the TerraUSD crash in May 2022 is the latest of many stablecoins that didn’t live their purpose. Investors panicked when the TerraUSD price started losing its peg against the US dollar, causing a run on its reserves, eventually leading to a “death spiral.”

Before jumping into examples of stablecoins that have crashed, let’s briefly discuss the types of stablecoins:

• Fiat-backed stablecoins They maintain equal reserves of their underlying assets, e.g., the USDC stablecoin.
• Crypto-backed Similar to fiat-backed stablecoins, but use cryptocurrencies as underlying assets, e.g. the Dai stablecoin.
• Algorithmic stablecoins They use algorithms to control supply and demand and maintain their price to the US dollar, like the Ampleforth stablecoin.
  

Examples of Stablecoins that Crashed

The little-known example of a stablecoin that crashed is Basis Cash, launched in 2020 and quickly vanished. At its peak, it recorded a market cap of $30.74 million. However, it could not maintain its peg and fell from $1 to $0.30 within one month.

The Basis Cash developers used a “seigniorage algorithm” in their project. Simply put, in a seigniorage system, two or more coins are created: one acts as a stablecoin, while the other operates like standard cryptocurrencies.

When the price of the stablecoin falls below $1, the investors of the sister token rush to buy it at discounted prices, pushing the price back to $1. Likewise, if the price exceeds $1, the project owners issue more stablecoins to lower their demand and move the price to its peg.

Interestingly, Terraform Labs leveraged the same method in their TerraUSD stablecoin. Keep reading to know why these two stablecoins with a high potential crashed.

Why Stablecoins Crash

Since the TerraUSD crash is still fresh in our minds, let’s use it to explain why stablecoins crash.

As mentioned, the TerraUSD stablecoin relied on the seigniorage algorithm to mint new or burn existing LUNA tokens to achieve its peg to the US dollar. When the Terra stablecoin fell below $1, the algorithm minted new LUNA tokens to buy it. Again, when the stablecoin rose above $1, the algorithm sold it and burned the existing LUNA tokens.

Now, as TerraUSD’s price continued to decline, the algorithm minted more LUNA to maintain the peg. But, as the algorithm continued minting more LUNA, the value of the underlying asset of TerraUSD also declined.

Consequently, the LUNA Foundation Guard—the organization established to support TerraUSD—bought billions of dollars in Bitcoin reserves as a backup. The foundation used some of its reserves to buy TerraUSD, but the experiment didn’t hold.