Recent events in the cryptocurrency sector may have made you doubt what so-called stablecoins are good for.

Sure, it's handy to keep a digital coin around that can act as a stand-in for the U.S. dollar (or another major world currency) as needed. A trading system built to manage blockchain-based cryptocurrencies must run smoother using a crypto-style replacement for ordinary currencies, so it makes sense that most of the leading stablecoins were created by, and used in, the world's largest cryptocurrency trading services.

But that's only true as long as the stablecoins are stable. When one of these dollar substitutes loses its connection to the currency it is supposed to be firmly pegged to, the related trading system can fail in a hurry.

So, how stable are these digital assets, really?

How smooth can a stablecoin chart be?

A stablecoin pegged to the U.S. dollar should always be worth approximately $1. The actual token price may sway a little bit in reaction to changing market conditions, and the actions that keep it close to its target price may not always have the desired effect right away. So if you check out the six-month pricing charts for three of the most important stablecoins over a recent six-month period, you won't see a perfectly straight line at $1.00 per token -- but the coins shouldn't stray far from it, either.

Tether Price Chart

Tether Price data by YCharts

During this period, none of the three stablecoins on the chart strayed more than 1.1% away from their perfect target price. Tether (USDT 0.02%) stayed particularly true to its design goals, while the TerraUSD (USTC 6.67%) and Binance USD (BUSD)exhibited slightly sharper spikes. All things considered, though, they all earned their stablecoin monikers, and they served their functional purpose as designed.

But in the past week, TerraUSD slipped far from its $1 target price. In just two days, the stablecoin dropped all the way down to $0.37 per token. In this context, the earlier chart squiggles look like forgettable rounding errors:

Tether Price Chart

Tether Price data by YCharts

What's wrong with TerraUSD?

Terra is different from most of its stablecoin peers. Tether and Binance USD are backed by actual cash and cash equivalents.

The market value of all existing Binance USD tokens is matched by money in a bank account controlled by the Paxos Trust company. That cash balance always corresponds to the token's market value, and the matching values are published at the end of each month. On March 31, the total value of the Binance USD tokens in circulation was $17.5 billion, and the Paxos account held that same amount in cold, hard cash.

Tether uses a more fluid collection of traditional assets to secure its dollar-based stablecoin. Most of these reserves consist of Treasury bills, certificates of deposit, and cash deposits. There's also a smattering of smaller holdings of precious metals, cryptocurrencies, and secured loans. But the principle is the same as Binance USD's, and Tether Holdings always maintains enough reserves to cover the actual market value of the stablecoins in circulation. On Friday afternoon, that meant $78.7 billion of market value backed by $78.7 billion in assorted assets.

TerraUSD doesn't work like that. Instead, the stablecoin's value is controlled by minting or burning tokens of the Terra (LUNC 1.44%) cryptocurrency. This system was designed to scale up very quickly, and the value-protecting transactions are executed by smart contracts on the Terra network.

This algorithmic stablecoin worked just great -- until it didn't.

On May 9, TerraUSD's trading volumes started to climb and the system started to struggle with burning enough Terra tokens. Soon, the Terra cryptocurrency was also losing value at a terrifying pace. Terra crashed from $60 per token on Tuesday morning to $0.0001 per token on Friday afternoon. That cryptocurrency is no longer solid enough to support a large stablecoin, so the whole two-token system is failing.

A person stands on a highway marked with the word Cryptocurrency. The road stretches up to form a huge question mark in the sky.

Image source: Getty Images.

Could this happen to other stablecoins?

TerraUSD is fundamentally different from most of its peers. Algorithmic stablecoins are a rare breed, and this event will make future stablecoin designers think twice before going down that road.

To be clear, TerraUSD did come with some unique benefits. For instance, the coin offered safe sky-high annual interest rates of nearly 20% on TerraUSD tokens that could be borrowed by investors in need of dollar-like capital. But if it sounds too good to be true, maybe it wasn't meant to be.

Future stablecoin designers will look at TerraUSD as an example of what not to do. But cash-backed stablecoins still look solid. It's also possible that the TerraUSD disaster could have been avoided if the developers had given some parameters more conservative values.

That said, regulators and lawmakers will probably look to the TerraUSD meltdown when they design legal frameworks for cryptocurrencies in general. So crypto investors will feel the ripple effects of this stablecoin collapse for years to come.