Leading stablecoin Tether (CRYPTO: USDT) saw its value fall as low as 95 cents — possibly a price not seen since 2017 — after Wednesday's collapse of TerraUSD (CRYPTO: UST) and its native protocol Terra (CRYPTO: LUNA) spurred fears of stablecoin instability.
What Happened: Tether's value dropped by about 5% on Thursday, as shown by market data, which follows the collapse of the TerraUSD stablecoin so closely that it is most probably a consequence of fears it may face a similar fate.
Still, the two stablecoins in question work on two completely different premises and Tether cannot fail for the same reason TerraUSD lost its peg to the United States dollar.
See Also: Is Terra (LUNA) Dead?
Tether promises that each USDT token is backed by $1 in a bank account. Of course, with those reserves being centralized and private, the best we can do is trust Tether and its auditors to be stating the truth; its bank balances are not publicly visible on a blockchain.
This is suboptimal and the dangers of such an approach were clearly shown to the world in mid-October 2021, when the U.S. Commodity Futures Trading Commission hit Tether with a $41-million civil penalty after finding that USDT was not always fully backed. To be exact, it was backed 27.6% of the time during the 26-month period under review between 2016 and 2018.
TerraUSD tries to solve this problem by using an algorithmic approach to ensuring that the stablecoin's value stays close to the $1 mark, which is "trustless," since everyone can check the system and there is no need to trust third parties. However, not everyone can read smart contracts and interpret complex blockchain transaction records.
Where Tether beats TerraUSD is simplicity in its implementation. Any engineer will tell you that the more complex a system is, the more likely it is to break — and in the case of information security, it is also more likely to contain vulnerabilities. As a consequence, USDT — with its extremely simple system and economics — is much less likely to fail due to a cyberattack or a failure in its economic ecosystem compared to UST.
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Instead of using tokens as simple symbolic representations of assets contained in a reserve like Tether, TerraUSD is deeply integrated into the Terra ecosystem and allows anyone to destroy $1 worth of Terra to mint 1 UST and 1 UST to mint $1 in Terra. The reasoning was that whenever UST traded above $1, users would be burning Terra to mint new UST to sell at a profit until the demand is met and the price stabilizes at $1.
When UST traded under $1, it could be bought and burnt to mint $1 worth of Terra to profit until the supply shrinks enough for the demand to stabilize around the $1 mark.
An unintended consequence is that if — as recently occurred — UST sees a price under $1 for a prolonged time, this results in sustained selling pressure for its reserve asset Terra, which is also paired with inflation of its supply.
On Wednesday alone, Terra's supply increased by over 9.5% due to its implementation as a reserve asset.
The two assets are tightly intertwined, and TerraUSD's drop as the stablecoin market lost confidence triggered a runaway reaction that resulted in $11.7 billion evaporating from Terra's market cap and $12.24 billion from TerraUSD's, all in one single day.
Now, such mechanisms do not play any role in traditional stablecoins such as Tether or USD Coin (CRYPTO: USDC), so such a scenario could not play out in their case. That being said, they are not without their dangers, but their dangers are mostly due to them having unverifiable backing that enables potential fraud. Another risk: an ever-evolving regulatory landscape that could suddenly declare them illegal.
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