In the past 12 months, the stablecoin market has seen unprecedented attention and activity. The number of stablecoin projects has grown substantially, with at least 41 distinct initiatives in development. Many of these new projects have received significant funding; for example, the venture capital firm Andreessen Horowitz recently announced that it had raised $300 million to invest exclusively in “crypto assets and equity” related to blockchain technology. The belief that there is demand for a token whose value is predictable stems from several factors. First, we are seeing an increase in adoption of digital currencies among retail and institutional investors alike. Second, current cryptocurrencies lack stability because their markets are subject to frequent speculation and manipulation; as a result, many investors who want to use them for everyday transactions or store value are cautious about buying them directly. And finally, we see growing interest among third parties who want to offer services such as payments or savings on top of blockchains like Ethereum without worrying about price fluctuations that would render their services unprofitable or cost much more than they budgeted.

How did we get here?

The birth of stablecoins as we know them can be traced back to the launch of the first cryptocurrency, Bitcoin, in 2009. From the outset, Bitcoin’s value was highly volatile, making it less suitable as a currency than as a speculative investment. In the years following Bitcoin’s creation, dozens of other cryptocurrencies, known as altcoins, were launched. Most of these were developed as improvements over Bitcoin, with a focus on addressing issues such as efficiency and scalability. The first stablecoin was introduced in 2014, when the startup Basis launched a token whose value was mechanically pegged to the U.S. dollar. The project failed less than two years later after struggling to build a reliable system that was adequately guarded against manipulation.

What happened with Terra?

Given this history, perhaps it’s not surprising that the most recent stablecoin to make headlines has also been the most controversial. Terra, whose value is pegged to the U.S. dollar, is one of the newer projects in the stablecoin space, having launched in October 2018. Terra’s design differs from previous stablecoins in a number of ways. First, it’s managed as a decentralized autonomous organization (DAO). Second, it doesn’t hold any assets against its liabilities — as is the case with most other stablecoins — but instead uses a collateral-free system known as the collateralized debt position (CDP).

Lessons from Terra’s fall

Many of the problems Terra experienced can be traced back to a combination of its complex design and the inexperience of its team. Terra’s CDP-based system requires a large amount of collateral to function, but the mechanism for setting this value doesn’t appear to have been adequately tested, as demonstrated by the dramatic drop in its price on March 26th, 2019. This event triggered the liquidation of CDPs, causing Terra’s price to fall by almost half. Furthermore, the Terra team failed to take corrective actions that would have allowed it to continue operating normally. Most importantly, the team didn’t address the root cause of the price drop — that CDPs were forced to offer collateral at a rate that was too high. Instead, it increased supply to regain its original price and reopened trading for only a brief period before closing it again. Given these mistakes, it’s not surprising that investors reacted negatively to the news.

Future of Stablecoins

The collapse of Terra shows that stablecoins are still in an experimental phase, and that the more ambitious projects will face real challenges. Moreover, it underscores the importance of imposing transparency and accountability measures on the industry to ensure that the problems of the past are not repeated. Fortunately, we are already seeing signs of increased attention to these issues. The Financial Stability Board, a global body that monitors and makes recommendations about the stability of the financial system, recently published a report on cryptocurrencies, concluding that they “pose no immediate danger to global financial stability.” There is also growing awareness in the blockchain community that stablecoins should be subject to the same oversight as other financial instruments.

Conclusion

As we’ve seen, stablecoins are still in their early days, and there is still significant risk of failure. That said, there is also tremendous potential for this technology to make a positive impact on the industry. Stablecoins have the potential to encourage adoption of cryptocurrencies by providing a bridge between the traditional financial system and the new blockchain-based economy.

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