By Elizabeth Howcroft

LONDON (Reuters] – While many cryptocurrencies are subject to price volatility, a sub-category is designed to preserve a steady value.

With bitcoin dropping around a third in value within eight days, cryptocurrency prices crashed this week. Stablecoins were meant to stay out of the chaos.

However, it was the sudden collapse of TerraUSD (the fourth-largest stablecoin) that brought this asset class back to attention. It broke with its 1 dollar peg.

Let’s find out what to do:

STABLECOINS: WHAT IS IT?

Stablecoins cryptocurrencies are designed to provide protection from wild volatility which can make it hard for digital assets to be used as payments or as a storage of value.

The goal is to keep the exchange rate constant with fiat currencies. This can be done, for instance, by a 1 U.S. Dollar peg.

HOW EXPORTANT IS THIS?

Stablecoins are valued at around $170 Billion, making them an insignificant part of the cryptocurrency market.

They have seen a rise in popularity over the past few years. Market cap for the largest stablecoin is around $80 Billion. This has increased from $4.1 Billion at the beginning of 2020.

CoinMarketCap data shows that the No.2 stablecoin has a market value of $49 Billion.

Although it is difficult to find data about the exact uses of stablecoins, they are crucial for crypto traders. They allow them to protect against bitcoin price spikes and store cash indefinitely without having to transfer it into fiat currency.

In its biannual financial stability report on Tuesday, the U.S. Federal Reserve https://www.federalreserve.gov/publications/files/financial-stability-report-20220509.pdf warned stablecoins are increasingly used to facilitate leveraged trading in other cryptocurrencies.

Stablecoins are increasingly being used for international trade, and to bypass capital controls. Joseph Edwards is the head of financial strategy at Solrise. He mentioned that Tether, the stablecoin is especially used in trade between China and South America.

WHAT DO THEY DO?

Two types of stablecoin exist: ones that are supported by assets such as bonds, fiat currency or commercial paper; and those that are algorithmic or “decentralised”.

Tether, USD Coin, and Binance USD are major stablecoins that have been reserve-backed. They claim they have enough dollars-denominated assets for a 1:1 exchange rate.

According to the companies, one stablecoin can be used for $1.

Recent years have seen asset-backed stablecoins come under increased pressure to make clear what their reserves are and whether they have enough money to cover all of the coins that circulate.

TerraUSD is an algorithmic stabilitycoin. It does not hold reserves. To maintain its value, a complicated system was used to swap TerraUSD coins and Luna cryptocurrency to create supply control.

What CAN GO Wrong?

TerraUSD’s stability system stopped functioning this week as investors lost faith and Luna became more volatile, as a result of a wider downturn in the cryptocurrency markets. TerraUSD fell to 30 cents.

The theory is that asset-backed stablecoins will hold steady despite these.

Tether, however, also cut its dollar peg on Thursday for the first-time since 2020. It dropped to 95 cents.

Tether attempted to comfort investors by stating on its website, that token holders could still redeem their tokens at the 1:1 rate.

What do regulators say?

Global regulators are working to create rules and regulations for cryptocurrency markets. However, many have identified stablecoins in particular as an issue for financial stability. For example, too many people trying to cash out of their stablecoins simultaneously.

Fed’s stability report warned stablecoins were vulnerable to investor runs. They are backed with assets that could lose value, or become illiquid under market stress. It warned that a run on the stablecoin could result in financial instability and spread to the rest of the traditional financial system.