Untangling the Collapse: How UST and Other Stablecoins Fell from Grace

While stablecoins have proven highly useful in trading, their success hinges on several key factors. Market confidence, collateral management, liquidity, and security are essential for the stability of these digital assets. As seen in previous examples, even one of these elements faltering can lead to the collapse of what was once a promising stablecoin. Here’s a closer look at the past events and current trends surrounding stablecoins and their vulnerabilities.

The Rise and Fall of Algorithmic Stablecoins

Algorithmic stablecoins, like TerraUSD (UST), used complex mechanisms to maintain their value. UST, for instance, relied on its sister token Luna (LUNA) and an algorithm to balance supply and demand. However, the major sell-off in May 2022 broke UST’s peg to the U.S. dollar, resulting in a catastrophic collapse. This event demonstrated how heavily algorithmic stablecoins depend on continued market confidence. Once trust erodes, these models can fail spectacularly, leading to significant instability.

Weak Collateral Management

Even collateral-backed stablecoins aren’t immune to failure. IRON Finance’s IRON stablecoin serves as an example. IRON relied on a combination of crypto and traditional assets, but a market panic in June 2021 triggered a mass sell-off of the platform’s governance token, TITAN, causing IRON to lose its peg. Insufficient collateral support worsened the situation, showcasing the dangers of poor collateral management.

Liquidity Issues

Liquidity is another critical factor for stablecoins. In August 2022, HUSD faced a liquidity crisis after market-maker accounts were closed during non-banking hours. Liquidity is crucial to absorb large transactions without causing major price fluctuations. A lack of liquidity can trigger market panic, even from minor sales, causing a stablecoin to lose value.

Risks of Centralized Control

Stablecoins with centralized control also pose significant risks. One of the first algorithmic stablecoins, Nubit (NBT), collapsed due to poor reserve management and panic selling. Centralized power in the hands of issuers can lead to abrupt policy changes or financial strain, which could be catastrophic for a stablecoin’s stability.

Regulatory Challenges

Regulatory pressure significantly affects stablecoin stability. Governments worldwide are still developing regulations for cryptocurrencies. Rapid legal actions, asset freezes, or audit demands can shake investor confidence. For instance, Binance USD (BUSD) issuer Paxos faced scrutiny from the SEC and the New York Department of Financial Services in February 2023, forcing them to halt minting operations. Despite regulatory challenges, BUSD managed to maintain its peg, showing resilience under intense pressure. However, ongoing regulatory trends will play a critical role in shaping the future of stablecoin models.

The Future of Stablecoins

The evolution of stablecoins depends on their ability to adapt to market changes, maintain stability, and mitigate the risk of collapse. The trend towards yield-bearing stablecoins is emerging, drawing regulatory attention due to their interest-bearing products. Some stablecoins are exploring over-collateralized reserves, which could be risky during adverse market conditions or unforeseen black swan events.

Stablecoins must navigate a complex landscape, from maintaining market confidence to managing collateral and meeting regulatory requirements. Only time will tell which fiat-pegged tokens will stand the test of time and continue to provide financial stability. Ironically, stablecoins’ stability is also tied to the reliability of the underlying fiat currencies. For example, the purchasing power of the U.S. dollar has declined by about 96.4% between 1913 and 2021, highlighting the complexities and uncertainties stablecoins face in the digital age.