In the turbulent and emerging world of digital currencies, stablecoins are known as islands of stability and peace. These cryptocurrencies, whose value is often tied to stable assets such as the dollar or gold, promise to protect users’ assets from the volatility of the cryptocurrency market and stabilize their value. Despite this ambitious claim, stablecoins themselves have always faced a series of threats and challenges that raise doubts about their stability and long-term success.
In this article, we will take a deeper look at some of the main reasons that can cause the price of stablecoins to fall and endanger the survival of these projects in the not too distant future. These reasons include a wide range of potential factors, from the inherent weaknesses of algorithmic stablecoins to the risks of security breaches and cyber attacks, from increasing competition in the market to the threat of the entry of powerful actors such as central banks.
The story of the falling price of the UST Luna stablecoin
One of the most important events that destabilized the stablecoin market in recent years was the collapse of the Terra USD project in May 2022. This stablecoin, known by the symbol UST, was one of the largest and most popular stablecoins on the market; But within a few days, it faced a significant price drop and its value reached almost zero.
TerraUSD was an algorithmic stablecoin that maintained its price stability not through dollar backing, but through a self-regulating mechanism. This mechanism was based on the balance of supply and demand between the two tokens UST and Luna (LUNA), which was the native token of the Terra network. When the price of UST went above $1, users were motivated to burn Luna tokens to create more UST and vice versa. This mechanism was supposed to keep the UST price close to one dollar in the long term.
Unfortunately, there were several structural weaknesses in the mechanism of this stablecoin, which made it vulnerable to malicious attacks and extreme market fluctuations. First, despite the claim of being decentralized, many of the Luna tokens were actually owned by the developer team and the big whales. This concentration of power increases the potential for market manipulation. On the other hand, there was no limit to the mechanism of burning Luna to create UST, and in case of massive selling pressure, the excessive supply of Luna could throw the entire system out of balance.
Exactly the same thing happened in May 2022. After a big whale sold a huge amount of UST, the price of this stablecoin experienced a sharp drop. Frightened users also joined the trend and fueled the price drop by massively selling UST and burning it to get Luna. Within a short period of time, the oversupply of Luna also brought down the price of this token. Within days, the price of UST fell below 10 cents, and Luna’s market cap fell by more than 99%.
The collapse of TerraUSD was not just a simple failure, it severely damaged public confidence in stablecoins. This event showed that the value of even seemingly stable stablecoins can drop to almost zero in a matter of days. After this incident, many investors were skeptical about investing in stablecoins, and the market of other popular stablecoins also faced capital outflows and a decrease in market value.
This failure also revealed the inherent weakness of algorithmic stablecoins. Unlike stablecoins such as Tether (USDT), which are backed by dollars, algorithmic stablecoins are designed solely based on software codes and economic incentives and lack reliable collateral. This feature makes them vulnerable to speculative attacks and market crises. It is enough to lose public trust in an algorithmic stablecoin for the entire system to collapse.
Inherent problems of algorithmic stablecoins
One of the main problems of algorithmic stablecoins is their strong dependence on market trust. To maintain price stability, there must always be a demand for stablecoin and its complementary token. If for any reason the confidence of the investors regarding the stability of the system is denied, the whole mechanism will collapse with the mass outflow of capital. In fact, these stablecoins need constant attraction of new funds to maintain their existence, otherwise they will face collapse.
On the other hand, algorithmic stablecoins are very vulnerable to malicious attacks. Market participants with sufficient capital can disrupt the price stabilization mechanism by creating artificial fluctuations in supply and demand. This is exactly what happened to TeraUSD and several other algorithmic stablecoins. The speculative attack with the massive sale of stablecoins led to the loss of price stability and the subsequent panicked withdrawal of funds from the entire ecosystem.
Besides TerraUSD, other examples of algorithmic stablecoins have also faced similar problems. For example, the stablecoin Basis Cash, which was launched in 2020, could not maintain price stability despite attracting large capitals at the beginning of its work and eventually failed. Empty Set Dollar (Empty Set Dollar) stablecoin also faced failure in 2021, after the price fell by 99%.
These successive failures have partially questioned the overall validity of algorithmic stablecoins. Many activists and analysts of the cryptocurrency market believe that a purely algorithmic mechanism, without collateral and valid supports, is not enough to maintain the stability of a stablecoin. In the absence of a stable asset as a guarantee of value, these cryptocurrencies resemble an elaborate Ponzi scheme more than they are truly stable.
Another thing to think about is that even if an algorithmic stablecoin manages to maintain its price stability by attracting huge funds, there is still a possibility that the whole system will collapse due to the sudden withdrawal of these funds. In fact, instead of being inherently stable, algorithmic stablecoins pretend to be stable by simply borrowing temporary stability from investors’ pockets.
In short, algorithmic stablecoins are exposed to serious vulnerabilities due to their structural nature. These cryptocurrencies have no collateral and real supports, and their stability depends solely on the trust of investors and the non-occurrence of speculative attacks. The repeated failures of projects like TerraUSD show the fact that the mere existence of an algorithmic mechanism is not enough to guarantee the long-term stability of a stablecoin, and these cryptocurrencies are still subject to extreme fluctuations and sudden collapse.
General challenges of stablecoins
Although algorithmic stablecoins are the most vulnerable to market fluctuations and speculative attacks due to structural weaknesses, the issue of instability and price collapse is not limited to this category of stablecoins. Other types of stablecoins such as fiat-backed stablecoins (such as Tether) and cryptocurrency-backed stablecoins (such as Dai) may also experience a decline in value. In the following, we will examine some general challenges that threaten the price stability of most stablecoins.
One of the most important issues that stablecoins are always dealing with is the regulation and supervision of legal institutions. Since stablecoins claim that each unit of their token is backed by a dollar equivalent, it is necessary to always observe financial transparency and ensure the existence of sufficient reserves by providing audited reports. However, many stablecoin issuers have fallen short in this regard, which has many times raised the suspicion of insufficient support. For example, Tether has repeatedly faced fines and legal investigations for not providing transparency about its reserves.
On the other hand, strict measures and sudden restrictions by regulatory bodies can negatively affect the stability of stablecoins. When the access of the issuers of stablecoins to the banking system and fiat exchanges is difficult, the possibility of price fluctuation and even their collapse increases. This is an issue that has previously challenged projects such as Libra (Diem), Facebook’s currency.
Another important issue is the risks related to the liquidity of stablecoin collateral. In order for a stablecoin to be able to maintain its long-term stability, it is necessary for its backing assets to have high quality, price stability, and quick liquidity. Relying solely on unstable cryptocurrencies or high-risk securities can leave the stablecoin issuer short of liquidity in critical market conditions. Also, there is always the risk that the support funds will be improperly managed due to mismanagement or fraudulent actions, and the publisher will not be able to respond to requests in the required time.
Finally, intense competition and the emergence of new competitors in the market of stablecoins can make their situation vulnerable. In recent years, several projects have entered this field and each one claims to provide a more stable and less risky structure than the competitors. The supply of new stablecoins can lead to the withdrawal of capital from existing stablecoins.
In general, stablecoins, regardless of their type and structure, face several challenges to maintain stability. Strict regulations, the possibility of a lack of support, the risk of mismanagement of reserves and competitive pressure are among the threats that can make even supported stablecoins face instability and decline in value. To overcome these challenges, stablecoin issuers need to focus more on transparency, proper management of reserves, diversification of the collateral portfolio, and strengthening of public trust.
The entry of central banks into the space of stable coins
We said that there are several risks to the activity path of stable coins; But one of the most important risks is the entry of a powerful actor called Central Bank into this game. With the possible entry of central banks into the field of stablecoins, we may see significant changes in this space, which can lead to a fall in the price of existing stablecoins.
Some central banks around the world have been exploring the idea of issuing their own stablecoins, known as central bank digital currencies (CBDC), for several years. These stablecoins are supported by the central bank and will be connected to traditional fiat currencies. Given the credibility and stability of central banks, the stablecoins they issue are likely to have widespread trust and acceptance.
The introduction of central bank stablecoins can have a significant impact on existing stablecoins. With the availability of this verified and of course regulated and legal option, users may prefer to turn to it. This can lead to the withdrawal of liquidity from the existing stablecoins, and as a result, sales pressure and a decrease in their prices.
In addition, central banks will likely impose stricter regulations on non-bank stablecoins to protect their dominance of the monetary system. These regulations can include higher capital requirements, stricter supervision and operating restrictions. Such actions could increase the operating costs of existing stablecoins and limit their ability to compete with central bank stablecoins.
However, we also need to consider the benefits that central bank stablecoins can bring to the cryptocurrency ecosystem. Such tokens can inject more liquidity and stability into the market and facilitate wider adoption of cryptocurrencies. Existing stablecoins can adapt to this changing environment by focusing on more specialized use cases, providing innovative solutions, and partnering with central banks.
Overall, the possible role of central bank stablecoins in the existing stablecoin market is a matter that needs to be carefully considered. Actors in this field must prepare themselves for future developments and explore ways of adaptation and innovation. Ultimately, the goal should be to create a more inclusive and stable financial ecosystem where different stablecoins can coexist.
Pessimistic scenarios for the future
So far, we have examined some of the reasons that can cause the price of stablecoins to fall; But this list can be longer and in fact, as the digital currency market grows more and more, stablecoins will face a series of other threats in the future. Let’s examine some of these threats that may become more serious in the future.
Scalability challenges
As the use of stablecoins increases, the demand for their supply and redemption will increase significantly. Issuers may face challenges in maintaining sufficient collateral reserves to keep up with the growing supply of stablecoins in circulation. If the number of users of a stablecoin is large, it can be complicated, time-consuming and difficult to quickly convert tokens into money or other digital currencies. These scaling problems can lead to various problems and even lead to a drop in the price of stablecoins.
For this reason, stablecoin publishers must implement strategies for effective scalability. Measures such as the implementation of a sharding system (similar to the Toon Coin system), layer 2 solutions, or offline settlement mechanisms are among the solutions to manage growing transactions and maintain price stability.
Cyber attacks and security breaches
Stablecoins rely on blockchain technology and smart contracts, which can be vulnerable to cyber-attacks, hacking, and security vulnerabilities. Attackers may exploit weaknesses in code, protocols, or underlying infrastructure to gain unauthorized access to or manipulate the supply or reserves of stablecoins. A successful attack or breach could lead to the theft or loss of collateral assets, disrupting the stablecoin’s support and undermining confidence in its stability. Cyber attacks can also disrupt stablecoin operations, affect redemption and production processes, and bring price volatility to these assets.
The solution is that stablecoin issuers should prioritize strong security measures such as regular audits, encouraging professional users to identify flaws and rewarding users who identify these flaws, and continuous monitoring to reduce the risk of cyber attacks and security breaches.
Competition and market fragmentation
As the stablecoin market continues to grow, more publishers and projects are likely to enter the field and increase competition. Market fragmentation, with multiple stablecoins competing for acceptance and market share, can create volatility and instability. Competing stablecoins may resort to aggressive advertising campaigns, offering incentives, or leveraging network effects to attract users and liquidity. A price war or speculative trading between competing stablecoins can lead to deviations from their desired fixed rates. It is even possible that the main stablecoins of the market want to merge into a single stablecoin, although such a scenario would probably entail concentration risks and systemic vulnerabilities.
Geopolitical risks
Stablecoins are often pegged to major fiat currencies such as the US dollar or the euro, which are influenced by geopolitical and economic factors. Geopolitical tensions, trade disputes, or economic instability in countries that export these currencies can affect their stability and price. Changes in monetary policy, such as interest rate adjustments or quantitative easing measures, can change the underlying value of the fiat currency and thus the stability of the stablecoin attached to it. Political or regulatory measures, such as sanctions or capital controls, can also disrupt the flow of fiat currencies and impair the ability of stablecoin issuers to maintain sufficient reserves.
For this reason, stablecoin issuers may need to diversify their holdings across multiple fiat currencies or explore alternative peg mechanisms to mitigate geopolitical risks and ensure long-term price stability.
conclusion
A closer look at the possible reasons for the fall of stablecoins reveals the fact that despite their attractive promises, these digital currencies are not immune to market vulnerabilities. A wide range of risks, from inherent weaknesses in design to external threats, have always been lurking in stablecoins, raising doubts about their long-term stability. Of course, this does not mean that stablecoins should be rejected completely, but rather, the strengths and weaknesses of these projects should be evaluated with a realistic view and away from prejudice.
The road ahead for stablecoins is not an easy one. Either by trying to overcome technical and security challenges, by standing up to intense competition, or by adapting to strict regulatory rules, these projects require double effort and constant innovation to establish their position. It is only by properly understanding market realities, strengthening technical infrastructure, and moving towards greater transparency and accountability that perhaps stablecoins can establish their place in the evolving digital currency ecosystem. Otherwise, maybe in the not too distant future we will witness the gradual decline of these famous stars, but not so low in the sky of cryptocurrencies!
Frequently asked questions
Is Tether an algorithmic stablecoin?
no Tether equivalent to circulating units has its own financial backing.
What reasons may cause the price of stablecoins to decrease?
Cyber-attacks, financial problems of projects and the imposition of strict regulations can negatively affect the price of stablecoins.
Has the price of Tether ever fallen?
Until now, Tether has not experienced a serious and long-term price fall.
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