Financial markets have been pressured in recent weeks. Measured in EUR, global equities are down roughly 10%, while government bonds have just recorded their worst start of the year in decades. Yet, all the draw downs pale compared to the one experienced by Bitcoin. At the time of writing, Bitcoin is down an impressive 50% from its peak, again measured in EUR. Yet, as the chart below shows, this is by no means extraordinary as these, and even bigger, draw downs occur every few years.

Another big test

However, this does not take away that the entire crypto ecosystem faces another big test. The credibility and viability of stable coins are on the line after one of the biggest, TerraUSD or UST, failed to keep its peg with the US dollar. Terra’s algorithm could not cope with the large selling pressure on UST that commenced during the weekend. This negatively impacted Bitcoin directly because Terra had to buy UST and sell Bitcoin to defend the peg.

Stable coins have become a vital part of the ecosystem because they function as native crypto dollars, reducing market volatility and enable investors to generate income or interest on their crypto assets within DeFi or Decentralised Finance. The collapse of Terra has resulted in a big drawdown of the so-called Total Value Locked (TVL), which is the sum of all crypto assets lent out or staked in within the DeFi markets through smart contracts. This creates volatility in and pressure on other stable coins.

And a good example of this is Tether, the biggest stable coin in the crypto space, with a market cap of roughly USD 75 billion. Unlike Terra, which uses an algorithm, Tether is backed by US dollars and other liquid, USD-like instruments. But there are doubts here, too, as Tether refused to disclose its holdings when asked by the Financial Times. And while there are sound reasons for not disclosing, Tether stated it would rather not reveal its ‘secret sauce.’ this obviously causes additional volatility.

Credibility and deep pockets

The stable coin story is not that much different from a country or central bank defending its currency peg. You need deep pockets and credibility to fight off market pressure. At least for now, this seems to be the case with other big stable coins like USDC and Binance USD. And recently, the price of Tether has also moved back to 1 USD.

In general, the credibility of stable coins backed by assets, preferably US dollars, is much more straightforward – you either have it or not – than for algorithmic stable coins, which will always raise the question of how ‘sound’ the underlying methodology is. In the case of Terra, several analysts and investor has raised their doubts about algorithmic stable coins.

What does this mean for Bitcoin/Crypto?

In the ‘real world,’ pegs are lost too. And occasionally by big, well-respected financial institutions. Just ask the Swiss Central Bank, which had to let go of the 1.20 peg with the euro back in 2015. However, a big difference with Terra is that the Swiss National Bank had the means and the credibility to limit the moves that followed it.

If uncertainty rises, prices will fall. And Bitcoin is no exception. The increased anxiety surrounding stable coins and the broader DeFi ecosystem means a bigger risk premium is required on the asset class. In addition, regaining trust takes time. At the same time, if doubts about the other stable coins can be taken away, this should allow Bitcoin and other Crypto to recoup some of their recent losses.

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