When is a stablecoin, not a stable coin?

As Ric predicted, algorithmic stablecoins Terra and LUNA imploded – causing some $60B of losses

In less than a week, Terra and LUNA stablecoins became worthless – leaving investors with $60 billion in losses.

Many are asking how this could happen. I’m asking how it took so long to happen. I say this because Terra and Luna represent a silly experiment in the world of crypto, an experiment that was doomed to fail. So the fact that they did is a story unique to themselves (and other coins like them) – with no lasting impact on or implication for other digital assets, most notably the two biggest: bitcoin and Ethereum.

Here’s what you need to know. Broadly speaking, crypto consists of two types: digital assets and digital currencies. The former have prices that rise and fall with investor sentiment; the latter are designed to maintain a stable value.

Bitcoin, Ethereum and about 10,000 other coins are assets, and not relevant to this story. It’s the digital currencies that we want to focus on. In order to maintain their stable prices, these stablecoins operate in a simple, straightforward manner: they take the money you give them and use it to buy US dollars. By maintaining this 1:1 ratio of coins to dollars, they assure investors their coins’ prices will forever avoid volatility.

Some of these stablecoins go beyond dollars, however. They buy US Treasuries, bank CDs and even, egads, commercial paper. But all of this is pretty vanilla, and investors have demonstrated little worry that the coin’s $1 price might fall.

But that’s not the case for one subset of stablecoins. These are called algorithmic stablecoins – and that’s what Terra and LUNA were. Instead of pegging themselves to the dollar, they pegged themselves to each other. Based on supply and demand, the project’s sponsors would use AI-generated algorithms to reduce the holdings of one in order to raise the other – thereby maintaining stable levels of both. Theoretically.

That theory came crashing down. When many suddenly demanded liquidation, the algorithm couldn’t keep up. That caused the prices to fall, slowly at first, and soon cascading downward in a death spiral. Within a week, both coins were worthless.

The incident deserves to worry everyone who owns algorithmic stablecoins. But that’s where concern should end. There’s no reason to fear stablecoins that are pegged to – and backed by – US dollars and T-bills. And there’s certainly no reason to fear other digital assets that don’t claim to offer stable prices in the first place, such as bitcoin and Ethereum.

But in a market panic, reason and logic are tossed aside. On the news of Terra’s and LUNA’s collapse, people started to panic-sell their bitcoin, too. Makes no sense, but since when are investors ever sensical?

Eventually, investors will realize that the collapse of a given stablecoin or two isn’t a condemnation of the entire crypto world, and price declines caused by the incident will be reversed. (Other issues might perpetuate volatility, but that’s another story.)

This saga offers many lessons:

  1. Make sure you and your clients understand what you’re buying.
  2. Don’t panic merely because others are. Remind clients of the reasons they invested, the value of diversification, and the importance of maintaining a long-term investment perspective.
  3. When investing in a technological innovation that’s rapidly evolving (and therefore inherently risky), don’t add to the risk by investing in the least proven, most questionable platforms offered. It’s risky enough to go to sea, so you should board an aircraft carrier instead of an untested rowboat.
  4. Don’t broadly brand an entire industry based on the activities or actions of specific players. The FAA grounded the Boeing 737 MAX after two deadly crashes; the agency didn’t ban flights of any other aircraft.

In the end, the Terra/LUNA fiasco will serve as boon to the further development of the crypto industry. Regulators and legislators will use the incident to accelerate implementation of much-needed consumer protection policies, and investors will be more careful when selecting their investments. It’s sad to see so many people lose so much money so quickly, but that’s part of the experience when dealing with innovation. My hope is that the lessons are indeed learned by all – and quickly.