Is it possible for stablecoins to crash?

The rapid growth in demand for “stable coins” is one of the main trends of the year in the crypto market.

Despite the presence of certain advantages for investors (especially during periods of general correction of digital assets), stablecoins – contrary to a common misconception – do not belong to the category of risk-free investments.

What are stablecoins? What is the secret of popularity?

The number of investors actively using stablecoins in market transactions is constantly growing. This is a type of cryptocurrency, and their rate is pegged to fiat or other assets (for example, gold). In the overwhelming majority of cases, we are talking about a link with the US dollar – the main reserve currency.

The total supply of stablecoins in the crypto market has been growing rapidly over the past two years and reaches $174.25 billion. Among the leaders are USDT ($78.14 billion), USDC ($46.05 billion), BUSD ($17.33 billion), UST ($12.34 billion). ) and DAI ($10.1 billion). A source – The BlockCrypto

There are two groups of reasons that push investors to transfer part of their funds to stablecoins. Firstly, it is the use of “stable coins” in trading and exchange strategies, especially in the short and medium term.

For example, if investors correctly assessed the high probability of a decline in the price of bitcoin and other major cryptocurrencies in late 2021 and early 2022, they could successfully transfer their assets to stablecoins or open a short position on the exchange for the BTC/USDT pair.

The second group of reasons is the perception of “stable coins” as absolutely reliable and risk-free investments. In addition, many stablecoins provide an opportunity to receive significant passive income through staking (long-term placement of coins in a crypto wallet in order to confirm transactions in accordance with the proof-of-stake algorithm).

Stablecoins with the highest rates of passive income from staking. Among the leaders are TerraUSD (20.63%), HUSD (11%) and USDX (10%). What’s more, the USDN stablecoin is over 96% staked. And this suggests that many investors are aimed specifically at passive income. A source – Staking Rewards

The first group of reasons for using stablecoins are quite logical and justified, but the second often reflects a misunderstanding of the market risks associated with such a strategy.

The difference between stability and lack of volatility

Strictly speaking, the term “stablecoin” itself is not entirely correct, which contributes to the spread of misconceptions leading to unreasonable investment decisions. Consider two definitions based, for clarity, on real examples.

Stability is the ability of a certain system to function independently of external influences and maintain its structure.

Volatility is an indicator that characterizes the degree of volatility in the price of an asset. Accordingly, low volatility implies minimal price volatility.

In our case, the following non-cryptocurrency examples may be useful.

1. Boom and crisis in the real estate market. Housing (apartments and houses) is an example of stable assets in the sense that they fulfill their functions. The built house is stable in terms of consumer functions (floors, number of rooms, area, etc.), regardless of changes in supply and demand in the market. But its market value fluctuates significantly, i.e. volatility can be quite high. For example, according to Realt, the price per square meter in Kyiv skyrocketed from $668 in early 2004 to $3,005 in August 2008, and then dropped to $1,512 by early 2012.
2. Pricing in the USSR. In the Soviet Union, the prices of many goods remained unchanged for many years, i.e. their volatility was either minimal or non-existent. But can they be called stable in the sense of performing their functions? No, because people often did not have the opportunity to buy these goods at prices set by the state (which led to a shortage of goods, the formation of a black market, etc.).

The main example of a highly volatile (but at the same time extremely stable) asset remains bitcoin. For example, in 2017, the price of BTC increased by about 20 times, and by the end of 2018, it decreased by about 6 times from the maximum values. But, despite all the fluctuations in prices, bitcoin performs its functions stably and effectively – making electronic payments between participants without intermediaries. The BTC network also automatically adjusts mining difficulty according to the energy resources of the miners. That is, even in the event of large-scale crises – for example, the ban on mining in China in mid-2021 – the functionality of bitcoin did not suffer, since the hashrate was automatically changed in accordance with the new conditions.

Bitcoin hashrate change during the year. Most notably, the sharp decline in hashrate in May – July 2021 after the mining ban in China. A source – BitInfoCharts

The situation with stablecoins is the opposite: although there are practically no changes in their fiat value in US dollars, these assets do not demonstrate a satisfactory level of stability.

The main risks of stablecoins

The main problem with stablecoins is that they may not be able to fulfill the declared function of free and instant conversion into US dollars. But the structure of such risks is somewhat different, depending on the type of stablecoin.

1. fiat-backed stablecoins. Each of them must be backed by US dollars at a ratio of 1:1. Most stablecoins fall into this category, including Tether (USDT), the top stablecoin by market cap. The problem is that part of their reserves may be represented by securities of relatively low quality, which cannot be quickly and without losses converted into US dollars. In particular, during the 2019 trial, it was established that Tether at that time was backed by reserves only by 74%, and customers were deliberately not informed about this.
2. Cryptocurrency-backed stablecoins. In this case, cryptocurrencies with a certain margin of value are used to convert them into dollars. For example, DAI involves the use of Ethereum in the amount of 150% of the required dollar value. In the event of a sharp decline in the price of the base cryptocurrency, its security may also not be enough. But, in our opinion, “stable coins” with cryptocurrency backing are still preferable than the first option. The fact is that the holders of such assets can form more rational expectations about their security and stability. In addition, the problem of low-quality and illiquid securities is absent in this case.
3. Stablecoins without collateral. Oracles (special crypto programs for analyzing market data) allow you to adjust the supply of stablecoins depending on changes in demand for them. For example, if it rises, additional tokens can be issued. If demand decreases, supply should also be proportionally reduced. Theoretically, such a system can function, but the problem is that it is based only on the trust of token holders. And when trust falls, the price of such coins can drop to zero. In particular, bitcoin was created, among other things, in order to ensure the independence of financial transactions from the degree of trust of participants in each other.

In addition to the risks mentioned above and caused by the technical implementation of stablecoin backing, there are the following factors that characterize the current state of affairs in the market:

• a rapidly growing variety of “stablecoins” with varying quality of collateral that is ignored by most holders;
• the increasing role of staking interest to attract users offered by various cryptocurrencies (it already exceeds 20% for TerraUSD);
• such a high yield can be achieved either by undersecuring stablecoins, or by investing in obviously more risky securities and projects.

How can a possible crisis develop?

Issuing a stablecoin is a lucrative business, and breaching 100% liquid US dollar backing can generate additional revenue. Given these two factors, a potential stablecoin crisis can be modeled in general terms.

As the historical example of the Amsterdam Bank shows (it effectively maintained 100% gold-backed liabilities throughout the late 17th and first half of the 18th centuries, but then became involved in various manipulations that provoked a full-blown crisis), even economic agents with a solid reputation can use various schemes to receiving unauthorized income.

With an increase in the number of stablecoins and an increase in staking rates, the quality of collateral will steadily decline. But the market can continue to grow as long as the demand for stablecoins is stable and coin holders continue to trust them.

But in the event of sharp fluctuations in the market or loss of confidence in a particular stablecoin, the existing collateral may not be enough to meet all obligations. The inevitable panic will lead to a collapse in the rate of this “stablecoin” and massive requests for security of other stablecoins. As a result, many other unsustainable projects can be identified. Under this scenario, some of these coins may cease to exist, and those that prove sufficient collateral will have the opportunity to strengthen their positions in the market.

Conclusions and recommendations

1. Stablecoins are not as stable as many investors and holders of this type of digital asset assume. Although the level of risk depends on the type of stablecoin, all of them do not fall into the category of risk-free investments.
2. Stablecoins can be useful in implementing some investment strategies, but an abnormally high percentage of staking may indicate serious problems with the liquidity and security of such coins in the future.
3. It is necessary to understand how stability (as the ability to perform basic functions under different conditions) differs from the absence of price volatility. Bitcoin, despite its high volatility, is very stable in its functionality. But stablecoins often sacrifice stability for the sake of capitalization growth – and without 100% liquid coverage in US dollars.
4. Current trends are setting the stage for a full-blown stablecoin crisis in the medium term: abrupt changes in demand or loss of confidence could expose the vulnerabilities of many stablecoins. At the same time, bitcoin and other major cryptocurrencies are able to grow steadily in the long term, even in a negative scenario for stablecoins.

Sources: Federal Reserve Bank of Atlanta, BDO, Forklog, BitInfoCharts, Realt, Staking Rewards, The BlockCrypto

Disclaimer. Investing in any financial asset carries the risk of losing capital. Nothing in this text can be considered an investment recommendation or an offer to buy/sell any financial instruments. For all their actions in the stock market, each investor bears full responsibility independently.