So let's start with this simple question then. What is a stablecoin? They're basically cryptocurrencies where the price is specifically designed to be pegged to fiat money like the US dollar, a cryptocurrency, or to even exchange traded commodities, such as things like precious metals or industrial metals. So remind the five-year-old to me what fiat currency means.
Ah, yeah. So fiat, you know, F-I-A-T money is a government issued currency. That's just not backed by a physical commodity, such as gold or silver, or rather it is backed by the government that issued it. Okay.
Thanks for clarifying. So back to stablecoins. Why do we need them? And if you want to use cryptocurrency, why not just use Bitcoin or Ethereum?
Oh, so the short answer to that is basically volatility. Now, traditional cryptocurrencies like Bitcoin and Ethereum, they swing wildly in prices, sometimes rising or falling more than 10% in a single day. Now, by comparison, traditional fiat currencies, their daily moves of even, you know, just 1% in forex trading is relatively rare. So all this volatility can be great for traders and speculators, but when we're talking about routine transactions, like, you know, making regular purchases, with a volatile currency makes it risky for both the buyer and the seller.
Yeah, I guess no one wants to be the famous person for paying 10,000 bitcoins for two pizzas. Oh, man, that poor guy. And of course, on the other side, merchants, you know, they don't want to end up taking a loss if the price of the cryptocurrency plunges after they just got paid in it. So now to solve all this and to serve as a medium of exchange, it helps with a currency relatively stable, assuring those who accept it that it will retain purchasing power in the short term.
Now, as the name implies, stablecoins aim to address this problem by promising to hold the value of the cryptocurrency steady. So essentially, stablecoins allow the crypto community to use advanced new DeFi systems with assets that have significantly less volatility in value than traditional crypto assets like Ethereum or Bitcoin. If I'm using something that's linked to the US dollar as a cryptocurrency, why not just hold US dollars themselves? Oh, so there are some benefits to cryptocurrencies, you know, in that they are decentralized.
And basically, I mean, they're not controlled by a single government entity like a central bank. So that's number one. And number two is that you can actually earn some much higher interest than US dollars in a process called staking, which we'll have to explain like I'm five in a whole nother episode. But essentially, you can earn pretty good interest on stablecoins, so at least at the time of this particular episode, really, you know, things can fluctuate in finance, as you know.
How do they keep a stablecoin stable then? What are the mechanisms? So this is really important to know. There's actually a number of ways that stablecoins work, or should we say try to work, because sometimes they don't.
And each method has their pros and cons. So let's start with the first and most straightforward method, basically something called fiat backed. It's described as something like, basically, imagine you give me one US dollar bill, and then I give you a token called USDT or USD tether. Now here, the value of stablecoins of this type is based on the value of the backing currency, which is held maybe by a third party regulated financial entity.
And this fiat backed concept is great and it's secure as long as you trust the custodian is actually holding the backing dollar amount that they say they are. Now, the cons here are that there is a, you know, a centralized control point that requires this trusted custodian. And there have been, already been some lawsuits, for example, for tether, the biggest one. One of the biggest and largest stablecoins by market cap has faced accusations of being unable to provide audits for their reserves while continually printing millions.
Okay, so other than fiat backed stablecoins then, should we know about some other forms? Another pretty common one is something called commodity backed stablecoins, which work pretty much in the same way, and cryptocurrency backed stablecoins, which tend to be a bit more complex. But you know, all of these are still in one big category where basically there is an asset backed reserve. The other one that's really been used this week is much more interesting and it's called algorithmic or seniorage style stablecoins.
Ooh, okay. So what are algorithmic stablecoins then? Let's explain. Okay, so algorithmic stablecoins, kind of like implied by the name, they utilize algorithms to control these stablecoins' money supply with some really fancy game theory, financial incentives, and essentially a central banker approach to the printing and destroying of the currency.
And the big examples of this are basis or Terra. Great, so let's end by using the recent news about Terra to maybe explain tangibly exactly how that algorithmic stablecoin works. So recently, a large stablecoin, actually the third largest, called Terra, just completely imploded. These coins introduce these automatic mechanisms whereby coins are added or removed from the supply to target a specific valuation.
Now, in the case of Terra, this is done actually by a secondary cryptocurrency that's not stable called Luna. Okay, so you've got Luna and Terra and they interact with each other, Terra being the stablecoin and Luna being the non-stable one. Correct. So the idea here is that if Terra for some reason starts trading at 97 cents, you could buy 100 Terra for $97, right?
And then destroy them, but in exchange, you receive $100 worth of Luna. And in the process, you have basically pushed Terra's price back towards that stable $1. Hmm, sounds fairly clever. So there's a self-stabilizing mechanism here that is until it all breaks out.
This is larger and larger quantities of Luna, but gives you no mechanism of converting that currency into something else. Now, what happened now is in May of 2022, Terra or UST, it broke its one-to-one peg with its price plunging all the way to 10 cents. Now, remember, it's supposed to stay at a dollar, so that's anything but stable. And Luna fell to virtually zero, like 0.0001 cents or something like that, down from an all-time high of $119.51.
The collapse wiped out almost $45 billion of market cap over the course of a week. Wow, so despite the name stablecoin, it is important to remember that they still involve some risk and are still at work in progress. Did you learn something new? If you did, send us an email.
We are at yourlife5thepodcast at gmail.com. We love hearing from you, especially like many listeners this week if you've got suggestions for what we should be covering. Thank you also to the community at r slash extendacamp5 and we will see you all next week.