Bitcoin Faces a New Threat: Algorithmic Stablecoins | Barron's

Demand for TerraUSD could impact Bitcoin.

Dreamstime

Stablecoins are supposed to be the boring tokens of crypto—designed to maintain a fixed $1 value. But one of the fastest-growing stablecoins—TerraUSD—may be creating new risks for Bitcoin and the broader crypto market.

Stablecoins act like digital dollars in crypto markets—many traders use them as a kind of parking spot for cash between trades. The largest ones are USD Coin and Tether, making up a combined 70% of the $186 billion stablecoin market.

Right behind them, however, is an “algorithmic” coin called TerraUSD. In the past year, its market cap has soared nearly 870% to $17.9 billion, making it the third largest stablecoin.

Like its more traditional peers, TerraUSD aims to maintain a fixed $1 price. But unlike its larger siblings—which maintain dollar-based reserves equal to their circulation—TerraUSD holds its peg by giving traders an arbitrage opportunity every time its price deviates from $1.

Terra’s protocol allows traders to “burn” TerraUSD in exchange for a dollar’s worth of another cryptocurrency called Luna. The trade makes a profit when TerraUSD’s price falls below a dollar. It also works in reverse—preventing TerraUSD from rising above a dollar. 

With a few exceptions, the system has largely worked to keep TerraUSD at a stable $1 price.

Yet Terra’s backers appear to be going a step further to try to prevent TerraUSD from “breaking the buck.” Terraform Labs founder Do Kwon recently pledged to stockpile a gigantic amount of crypto, including at least $10 billion in Bitcoin, to help backstop TerraUSD.  

That is raising concerns that TerraUSD may not be as algorithmically stable as it would appear. And $10 billion isn’t a trivial amount of Bitcoin to hold as a reserve asset tied to TerraUSD; if Terraform had to sell some of its Bitcoin to meet redemption requests for TerraUSD, it could destabilize the broader crypto market.

“The efforts to stabilize one crypto asset might create more instability in other crypto assets,” said University of Calgary law professor Ryan Clements, who has researched stablecoins including TerraUSD. “If they have to redeem Bitcoin to support the peg, could that put downward pressure on Bitcoin? It would seem that would be the case, just logically.”

Terra’s algorithmic process has faltered. As the crypto market crashed in May 2021, TerraUSD temporarily broke its peg, moving to as low as 94.5 cents on the dollar, though it recovered within a week. Other algorithmic stablecoins, like one developed by Iron Finance, have completely collapsed.

One other concern is that much of the demand for TerraUSD comes from yield-seeking investors using a crypto savings product called Anchor Protocol. Anchor, which is built on the Terra blockchain network, currently offers a yield of more than 19.5%.

If investors lose confidence in Anchor and try to take their money out, it could lead to a cascading loss of demand for TerraUSD, potentially endangering its dollar-peg. That’s where Bitcoin may come in.

To help prevent a run, Kwon and others formed the “Luna Foundation Guard,” a Singapore-based nonprofit that, among other tasks, would build a giant crypto reserve to support TerraUSD. With $10 billion worth of Bitcoin, it could soon become one of the largest holders in the world.

The problem, according to Clements and others, is that it’s unclear whether the Bitcoin market has enough liquidity to absorb rapid selling from a Bitcoin holder that large. Just $32 billion worth of Bitcoin traded in the last 24 hours, according to CoinMarketCap, amounting to less than 4% of the coin’s market cap of $811 billion.

“If you liquidate $50 billion in Treasuries, that’s not going to tank the U.S. economy,” said Clements. Bitcoin may be far more vulnerable to a wave of selling by the Luna Foundation, which could be the token’s new “whale.”

Terraform Labs and the Luna Foundation Guard didn’t respond to requests for comment.

Write to Joe Light at [email protected]

social experiment by Livio Acerbo #greengroundit #bitcoin – original source here