Spotting Stablecoin Red Flags: Avoid the Next Collapse

Everyone involved in (and outside of) the crypto world felt the death of Terra's UST stablecoin, and the repercussions were so severe that they brought down multiple crypto lending platforms, a multibillion-dollar hedge fund, numerous projects built on Terra's blockchain, $18 billion in user funds, and $60 billion from the cryptocurrency market. Although this sad incident has made people wary of cryptocurrency and stablecoins, it's actually a particular kind of stablecoin that crashes in this way.

Cryptocurrencies known as stablecoins are fundamentally different from digital money and are pegged to the dollar. Stablecoins were developed to prevent retaining digital currency in an exchange account because cryptocurrency exchanges have a long history of losing users' funds and cryptocurrency as a result of hacks or administrative negligence. Cryptocurrencies and stablecoins are secure from exchange problems as long as they are withdrawn from an exchange. Knowing which stablecoins to trust is essential to protecting capital since stablecoins are today's lifeblood of Decentralized Finance (DeFi), a sector that employs blockchain smart contracts to rebuild banking services for cryptocurrencies.

Although there is a chance that a stablecoin will collapse, the cause and likelihood of this will depend on the stablecoin's variety. The four varieties of stablecoins are discussed in 101 Blockchains: algorithmic, cryptographic, fiat-backed, and commodity-backed.

The most reliable stablecoins are fiat-backed ones (USDT, USDC), which are backed by cash or "cash equivalents" kept in a bank account.

Crypto-backed stablecoins (DAI) are less stable than fiat-backed stablecoins since they are backed by "collateralized debt positions," or cryptocurrency deposits used as security for a stablecoin loan.

The least stable stablecoins are algorithmic stablecoins (UST), which are supported by an algorithm that creates or destroys tokens to maintain its peg.

Additionally, there are stablecoins that are backed by commodities rather than fiat, known as commodity-backed stablecoins.

Remember that stablecoins are very different from virtual money, and virtual money won't have the same issues or benefits as stablecoins.

All stablecoins have a reasonable degree of volatility, which frequently varies by approximately 0.01% of $1 due to open market buying and selling activity. They can all potentially lose their peg to the dollar during periods of high volatility, which occur when their market values fall or rise by more than 1%, although the majority can regain their peg. A "death spiral," which occurs when holders lose faith in the stablecoin's worth and rush to cash out their cryptocurrency in a frantic frenzy, can occur with some, bringing the price to a standstill. Algorithmic stablecoins are the most likely of the three to experience a death spiral because they lack backing assets that can be redeemed during periods of high volatility and because no algorithm has yet been developed that is resistant to widespread panic.

Often, a quick search on CoinMarketCap or CoinGecko will show if a stablecoin is algorithmic, cryptographic, or fiat-backed. If it isn't stated in the token's description, the information can be found by clicking the website link and browsing the site's main page. It is a fiat-backed stablecoin if it is issued by a corporation that keeps cash in a bank account and publishes reports on its asset reserves, such as Tether's USDT or Circle's USDC, and it will only collapse if the company is found to be lying about its reserves (which regulatory oversight protects against). If the stablecoin is backed by a cryptocurrency and is available through a DeFi application, such as Maker Protocol's DAI or Aave's new GHO stablecoin, it is a crypto-backed stablecoin and will only fail in a rare, unusual set of circumstances. It is best to stay away from algorithmic stablecoins if they are too complex to understand and don't involve cash reserves or collateralized cryptocurrency deposits.

If a stablecoin death spiral's version is recognized, avoiding it should be simple. Even though this is a gross oversimplification of stablecoins' operation and the reasons why they fail, it can help you avoid suffering significant losses due to death spirals. In conclusion, crypto-backed stablecoins are more volatile but still very resilient, while algorithmic stablecoins will crash when everyone panic-sells their holdings. Fiat-backed stablecoins are the most stable and durable and are essentially unbreakable.