What Happens to Stablecoins If the Fiat Market Crashes?

 

When people speak about market crashes in crypto, they are usually referring to the old-school giants of the industry such as Bitcoin, Ethereum, Litecoin, and maybe XRP. But there is another type of crash that could harm the industry, coming from a very unlikely source: stablecoins. Despite what their name suggests, stablecoins are actually quite far from stable, and they are certainly prone to risks. In particular, if the fiat asset a stablecoin is backed by falls, then the stalbecoin falls, too.

 

This has huge implications for the crypto industry, but it is especially important for those who borrow and lend. Many crypto lending platforms rely on stablecoins, especially DeFi platforms that use liquidity pools. If a fiat crash was to occur, it could cause some of these projects to collapse. Let’s scrutinize this concept, and see what it means on a wider scale.

 

Understanding Underlying Assets

 

Practically all stablecoins are pegged to a fiat asset. This can happen in several ways, but the most common method is for the company behind the stablecoin to keep stores of that fiat coin. This acts as its underlying asset, although some projects such as USDC utilize other underlying assets, too. The idea is that, for every stablecoin which enters circulation, the company behind that coin will have a reserve of value equal to that of the stablecoins in existence.

 

For instance, if there were 100 USDC in circulation, then Circle (the company behind the coin) would be expected to have $100 in their possession, designed to match it. This is the simplest way to achieve so-called stability. But what happens if the price of the US dollar dramatically changes?

 

If the dollar began to drop in value, and even lost its world-currency status, then all stablecoins pegged to the dollar would lose an equal amount of value. This is because all the reserves would drop in value, too. This is a strange dilemma, as it seems there is no way to really prevent this whilst still pegging a crypto to a fiat coin.

 

Crypto’s Relationship to the Fiat Markets

 

It should be unsurprising to hear that the crypto markets respond to other, external, markets. After all, there is a sizeable overlap of people who trade crypto as well as stocks, bonds, and forex. With that being said, the crypto markets are not always correlated to more traditional markets.

 

The most visible time this has happened is actually right now. Many, many, countries have been hit by a period of recession, or are at least somewhat close to entering one. And yet, despite this, Bitcoin and Ethereum have been hitting regular all-time highs throughout 2021. This reveals an interesting pattern– it appears crypto generally responds well to periods of economic hardship. This is not the first time something like this has happened. Bear in mind, Bitcoin was born out of the ashes of the 2008 economic crisis. When the traditional markets are failing, people seem to look for alternatives, and crypto appears to be the perfect solution.

 

Behavior like this suggests the crypto industry will be greatly successful if the rest of the economic world fails. But that may only be the case so long as no major currency experiences a drop so significant that it enters hyperinflation. Because if that happens, then the stablecoin market will get dragged to the ground, too.

 

For crypto lenders, this is worrying news, as it means their finances will be crushed. If somebody lends 100USDC for four months, and within that time, the dollar market becomes unstable, then when the borrower pays back the 100USDC, it may have tremendously reduced in buying power. If the dollar actually crashes, then when the loan is paid back, it could have practically zero buying power.

 

How Likely is This?

 

It has been a long time before a major Western country entered a state of hyperinflation. The last time this happened was in 1923 in Germany, occurring just after WWI and acting as a catalyst for WWII. At one point, the cost of living was doubling every four days.

 

Usually, it takes a huge event (such as a war) for hyperinflation to begin, and for several decades, the West has not seen anything life-changing and history-altering that could pose such a threat…. That was until COVID-19.

 

The global pandemic has ripped holes into most country’s budgets, with the US being one of the most affected. Some of this damage was merely due to the cost of surviving a pandemic, and other damage was due to poor monetary policy. This has led the Federal Reserve to print and distribute more US dollars for the purpose of stimulus and infrastructure. In an attempt to keep the economy afloat, they have printed at least 1/5 of all circulating dollars in the last year. As a result, it has triggered some intense spikes in inflation.

 

The Federal Reserve keeps protesting this inflation will be transitory, meaning it will not extend too far in time, however, others such as Deutsche Bank and the billionaire investor Stanley Druckenmiller disagree. It may still be unlikely that the US dollar will fully crash, but there is still a reasonable possibility.

 

How Can We Avoid This?

 

There is very little we, as citizens, can do to prevent hyperinflation, as it relies on the actions of governments and institutions, but there are some things the crypto industry can do to insulate itself against such a disaster. For starters, the industry needs to move away from fiat-backed stablecoins. So long as crypto relies on fiat activity, it will always be in the crosshairs of hyperinflation. We need stablecoins that are backed by other assets, such as perhaps gold, or even commodities. Theoretically, with the invention of real-time blockchain oracles, a stablecoin could be backed by more or less anything, such as ETFs based on luxury goods, healthcare, or funeral services (all of which are relatively depression-proof).

 

Another option would be to start tracking price against old financial values. For instance, AMPL is designed to stay within the price range of $1.00, circa 2019. This means that even when inflation rises, the coin itself is never affected, as it is stuck at a rate that does not react to current affairs.

 

It is preferable for lenders to keep an eye out for assets like this, as it may give them extra protection, should a fiat market crash happen. Essentially, if the dollar market looks like it is about to go into freefall, then it may be smart for lenders to use any cryptocurrency that derives its value from something other than USD. In a time like that, BTC might even be a safer bet than USD-backed stablecoins.

 

Keep in mind this is merely a “worst-case scenario”, but as a financially invested and active lender (or borrower), scenarios like this are important to think