Recent events – like the Terra (LUNA -0.70%) crash, Celsius bankruptcy filing, and crypto winter – have reminded us that cryptocurrencies are inherently volatile. This can certainly be discouraging to cryptocurrency investors, but there is one type of cryptocurrency that aims to limit this turbulence: stablecoins. Stablecoins are meant to retain constant value over time by linking their value to that of a stable asset. So what does this mean for investors? Let's take a deeper look at what a stablecoin is and whether it could be a good addition to your portfolio. 

How do stablecoins work?

Stablecoins work in a variety of different ways, depending on their type. The four main types of stablecoins are:

  1. Fiat-collateralized stablecoins: This type of stablecoin uses a reserve of fiat currency as collateral. They are commonly backed by the U.S. dollar, but there are also stablecoins pegged to the Japanese Yen, the Euro, and other currencies. Additionally, stablecoins may also be backed by a different combination of fiat currencies. An example here is Tether (USDT 0.04%). 
  2. Commodity-collateralized stablecoins: These stablecoins are backed by commodities like gold or silver. As the value of the commodity rises, so does the value of the stablecoin. Check out Paxos Gold (PAXG 1.09%) as an example. 
  3. Crypto-collateralized stablecoins: Just as it sounds, crypto-collateralized stablecoins are backed by other cryptocurrencies. In order to adjust for the volatility of other cryptocurrencies, this type of stablecoin is typically over-collateralized – meaning that the value of the reserve cryptocurrency exceeds the value of the stablecoin. Overcollateralization reduces the risk that a drop in the value of the reserve cryptocurrency could fall below the value of the issued stablecoins. Dai (DAI -0.06%) illustrates this type of collateralization. 
  4. Algorithmic stablecoins: Rather than being pegged to a reserve asset as collateral, a preset algorithm is in charge of controlling the supply of stablecoin in the market. Algorithmic stablecoins typically link two coins together and adjust prices based on the coins' fluctuations. But they may also lack transparency, and they are subject to volatility, and overall redemption risk – which is simply to say that the coins can be unstable. In times of crisis, like the Terra crash, there is no safety net.

What really happened to Terra Luna?

The Terra blockchain was launched in April 2019 by two Korean businesspersons, Do Kwon and Daniel Shin. Terra offered several stablecoins including TerraUSD as part of a global payment platform. Terra's native crypto token LUNA was used for several purposes, including staking, governance, and as part of the supply control mechanism that kept the algorithmic stablecoins pegged to their fiat equivalents.

The idea was to employ a complex arbitrage mechanism sustaining the peg to the dollar so that collateralization was no longer necessary. Unfortunately for terraUSD and LUNA holders, the mechanism was not bulletproof. In early May of 2022, some seemingly malicious market activity unfolded. A set of large investors suddenly sold tremendous volumes of UST on several platforms, and also shorted LUNA. In the resultant downward price spiral of both UST and LUNA, demand for both tokens evaporated. 

The original Terra network is now known as Luna Classic (LUNA -0.70%), and is nearly inactive. The new Terra network -- produced as a hard fork of the code -- no longer offers algorithmic stablecoins. Terra was the second biggest crypto network behind Ethereum. Terra's unexpected crash has led many observers to doubt the reliability of market capitalization value as a sufficient indicator of crypto network legitimacy and health. 

Furthermore, as a marketing strategy, the Terra network introduced "the anchor protocol," which created demand by promising consumers a guaranteed 20% APY (Annual Percentage Yield). In March 2022, Mr. Kwon announced that it was lowering its yield rates in order to become more sustainable over time, in effect acknowledging that their initial 20% return was not realistic.

How stable are stablecoins, really?

If operating with fiat-collateralized stablecoins, the value of the reserve currency will impact the value of the stablecoin. As the U.S. combats rising inflation rates (9.1% year-over-year as of June 2022), the value of fiat-collateralized stablecoins like Tether or USD coin become more inflated as well. Variation in the underlying asset due to inflation will reduce the stability of the cryptocurrency. In reality, stablecoins may not be as stable as they sound. 

So, should I buy stablecoins?

Stablecoins do provide an interesting proof of concept as to how our economy might move toward a cashless future but do not provide any worthy advantage at this time. With interest rates on the rise, there's no reason to use stablecoins instead of the cash equivalent products offered by certified financial institutions. If you do need to hold digital coins, make sure that any stablecoin you hold is properly collateralized.