The risk of a Stable Coin like LUNA lies in its reserves
The 99.99% fall of Luna from US$ 40 Billion to close to US$ 0.6 Billion within THREE days has questioned the idea of Stable Coins.
What are Stable Coins?
Stable Coins are cryptocurrencies the value of which is tied to that of another currency, commodity or financial instrument. Like Tether USDT is tied to US$.
Why do they exist?
They provide an alternative to highly volatile cryptocurrencies like Bitcoin, Etherium etc.
High volatility makes a currency less suitable for transactions. Imagine someone pays for your service in BTC and then the next day BTC price drops by 10%. Suddenly your work seems 10% less valuable than it was just a day before.
The point of any currency is to use it to transact with peers in the system/market.
But as transactional tokens a lot of crypto currencies are failing to prove useful. That’s where Stable Coins like Tether USDT and Terra LUNA come into the picture.
How do they tie their value to other currencies?
By maintaining reserve assets as collateral or through algorithmic formulas that are supposed to control supply. Much like the Central banks do by maintaining Gold and foreign exchange reserves.
What happened with Terra Luna?
Well, Luna was experimental. And when things got heated it couldn’t hold itself together. It was a risky Stable Coin because the reserves it held were in the form of BTC among other assets. Unfortunately BTC went down by drastically, and the market as a whole was moving downwards and LUNA algorithms failed to ride the tide.
Some Stable Coins like Tether USDT maintain a large amount of reserves in Cash and Cash Equivalents. Some reports claim close to 70% of USDT’s reserves are held in Cash and Cash Equivalents including close to 40% held in Commercial Paper.
While Luna has fallen, USDT has largely maintained its value close to the US$. But the fears in the market might erode that too.