U.S. dollar stablecoin Tether (USDT -0.03%) is the largest stablecoin by market capitalization in the world and the third largest cryptocurrency period, trailing only Bitcoin and Ethereum. And on May 12, Tether did something it's never done before. The stablecoin is supposed to always be worth $1. But during the early morning hours, it dropped to about $0.95 -- a shocking drop.
Tether's 5% deviation from its $1 peg is particularly jarring right now because of what just happened with rival stablecoin TerraUSD (USTC 1.02%). TerraUSD lost its $1 peg a few days ago and has traded as low as $0.30 per coin. And it's possible it will never recover.
In this article, let's briefly look at stablecoins and what might be next for Tether and for the cryptocurrency space as a whole.
Image source: Getty Images.
How the top five stablecoins work
According to CoinMarketCap, the top five stablecoins are Tether, USD Coin (USDC -0.00%), Binance USD (BUSD), TerraUSD, and Dai (DAI 0.01%). Yes, shockingly, TerraUSD is still a top five stablecoin by market cap even though it's only worth $0.45 as of this writing.
These stablecoins have different approaches to keeping their values at $1. Tether, USD Coin, and Binance USD keep real dollars in a bank and issue new digital coins at a one-to-one ratio.
This is probably the most intuitive way to build a stablecoin. However, the cryptocurrency community has been reluctant to embrace this approach. After all, what's the point of all of this if we still need real dollars at the end of the day? That's why Dai and TerraUSD approached the problem from different angles.
With Dai, users deposit cryptocurrencies like Bitcoin into vaults using The Maker Protocol from MakerDAO. Once deposited, new Dai is created. But there's supposed to be more collateral in vaults than Dai in circulation. This absorbs volatility in the underlying collateralized cryptocurrencies and the system has historically worked ok -- in times of extreme volatility Dai has deviated from its peg, but it's always managed to regain its $1 value.
Finally, we come to TerraUSD. This stablecoin attempted to control supply to always meet demand. More TerraUSD could enter and leave circulation based on demand by swapping it with Luna. This algorithmic stablecoin was an attempt to be fully decentralized.
Why TerraUSD failed
As mentioned, Tether recently started teetering. But it all started with TerraUSD.
People were putting their money into TerraUSD largely because of the high yield they could get for holding it through the Anchor Protocol. The annual percentage yield (APY) is about 20% -- extremely generous. However, according to DefiLlama, roughly $2.2 billion of TerraUSD was withdrawn from Anchor in 48 hours (May 7 through May 9) while the price of TerraUSD was still near $1.
This quickly flooded the market with TerraUSD coins. Ideally, users would have burned TerraUSD coins and exchanged them for Luna tokens to remediate the sudden supply and-demand imbalance. However, Luna was also falling hard at the time, demotivating users to exploit the arbitrage opportunity. And once this tandem downward spiral started, it couldn't recover. Luna has dropped 99% in value and TerraUSD hasn't been within 1% of its peg in almost four days.
There's much more to this story. But the point is, TerraUSD seems to have failed. And, more broadly, the market has lost total faith in the algorithmic stablecoin system. Consider that Neutrino USD and Waves is a similar algorithmic approach to stablecoins like TerraUSD and Luna. But Neutrino USD is also off of its peg and Waves token has dropped in value.
Some suggest that what happened with TerraUSD was a premeditated attack and there's some evidence of that. However, whether or not someone intentionally flooded the market to shake confidence in the system, the fact is it did happen. And if it happened once, it could happen again.
What's next for Tether
Now we finally come to Tether. During the early morning hours, Tether dropped from its peg. It's hard to decipher exactly what's going on but here's one data point: Curve allows people to exchange cryptocurrencies and its liquidity pool is supposed to be perfectly balanced between Dai, USD Coin, and Tether. As of this writing, Curve is 82% Tether, suggesting people are exchanging it for Dai and USD Coin in masse.
Whether or not someone is behind this isn't the point. The point is confidence in Tether appears to be shaken and it lost its peg as a result.
Unlike TerraUSD, Tether holders have options if it loses its peg. Since it's supposed to be backed by real dollars, holders can redeem them. According to the Tether team, $300 million has already been redeemed directly and it's on track to process a whopping $2 billion so far.
These redemptions are perhaps calming panic and restoring confidence to Tether. As I write, its price has climbed back to within 1% of $1. And the crypto community is certainly breathing a collective sigh of relief. The crypto market is rife with leverage -- something I don't recommend using for investing in stocks or cryptocurrencies. If Tether falls like TerraUSD, it could set off a chain reaction of margin calls to the detriment of the entire space.
Many have questioned Tether's reserves in the past and predicted a doomsday scenario if what's happening today actually happened. So far, Tether is mostly holding up against the extreme market volatility. But it looks like the situation is far from over. Therefore, cryptocurrency investors should be watching for further developments with extreme interest.
