Panics and death spirals: a history of failed stablecoins

After the stunning fall of Terraform Lab’s Terra USD stablecoin sent shockwaves through the crypto markets that wiped out some $200 billion in wealth in just 24 hours, the public—and many government officials—are questioning just how “stable” these stablecoins really are. But Terra isn’t the first stablecoin to tumble. 

??The idea behind stablecoins is that, unlike other forms of cryptocurrency which often have wildly fluctuating prices, a stablecoin is pegged to a more sturdy asset, usually the U.S. dollar. It’s designed to offer the benefits of paying with cryptocurrency without the wild price swings. Or at least, that’s how it’s supposed to work.

The problem happens when the price significantly deviates from the peg. Investors panic, there’s essentially a run on the bank, and the coin falls into a “death spiral,” which is what happened with Terra USD (UST). 

There are three main types of stablecoins: fiat-backed (in which the token maintains equal reserves of the currency it’s pegged to); crypto-backed (in which the token is collateralized by cryptocurrencies); and algorithmic (in which the token relies on algorithms to regulate supply and demand in order to peg its price to a dollar). 

UST is a blend of crypto-backed and algorithmic (not all algorithmic stablecoins are backed by an asset). Historically, most of the stablecoins we’ve seen fail have been algorithmic.

Stablecoins that weren’t

The most infamous example of a failed stablecoin was Basis Cash, which launched in late 2020 and quickly flamed out. At its peak, Basis Cash had a market capitalization of $30.74 million. Basis Cash struggled to hold its peg, falling from $1 to $0.30 in the month of January 2021.

The project used what’s known as a “seigniorage algorithm.” In this system, two (or more) tokens will be created: One will be the stablecoin, and the other a token that is free to move like any other token. When the price of the stablecoin goes below $1, holders of the second token will be able to buy the stablecoin at a discounted price. This pushes the price back to $1. In the case that it goes above $1, more of the stablecoin will be created and distributed across the network, pushing the price back down to its peg.

This is a similar system that Terraform Labs adopted with its LUNA and UST tokens. (CoinDesk recently reported that Do Kwon, the founder of Terraform Labs, was one of the pseudonymous founders of Basis Cash.) 

Another big seigniorage-algorithmic stablecoin that failed was Empty Set Dollar, which also launched in late 2020 and peaked at a market cap of $22.74 million. Within months, the token lost its peg to the U.S. dollar and began a descent to less than $0.01.

Then there was the death of Iron Finance‘s stablecoin in June 2021, which wiped out the holdings of investors, including Mark Cuban, who quickly called for regulation in the space. That stablecoin used a partially crypto-collateralized seigniorage algorithm, similar to the system that Terra adopted with UST. When Iron’s TITAN token became overvalued, a lot of big investors sold, the stablecoin depegged from the U.S. dollar, and—you guessed it—another death spiral.  

Although these are the biggest stablecoins to fail, many others have tumbled before they could do major damage. Other stablecoin projects that depegged and never recovered include SafeCoin, BitUSD, DigitalDollar, NuBits, and CK USD.

Can UST come back?

Things look extremely bleak for Terra. There has been at least one stablecoin to recover from a death spiral, but the situation was different.

Stablecoin OUSD was hacked back in November 2020, which led to the price plummeting to $0.14. Its price didn’t move for months, leaving investors sweating. It was able to successfully relaunch in January 2021, has remained close its $1 peg, and has increased its market cap to just over $60 million from less than $1 million before the hack.

In any case, the fall of Terra and the ensuing crypto crash have led to calls for more regulation of the industry. It has also raised fresh concerns about Tether, the largest stablecoin, which briefly lost its peg to the U.S. dollar in the wake of UST’s collapse. Tether claims to be a fiat-backed stablecoin, with backing of cash or “cash equivalents.” However, Tether has previously been fined by the U.S. government for allegedly misstating its reserves and has since failed to be as transparent about its reserves as many would like.

Following UST’s tumble, the U.S. Treasury Secretary Janet Yellen said that she hopes Congress can pass legislation to create a regulatory framework for stablecoins sometime this year.