Depegging of algorithmic stablecoin TerraUSD
What happened to UST and stablecoin regulation talks
This week was another chaotic one, as the crypto industry experienced the loss of one of its major stablecoins. Such an event follows closely to the discussion last week about the bear market wiping out projects that aren’t able to live up to their value propositions. In this newsletter, I cover what happened with UST and current regulatory talks around stablecoins.
I hope you enjoy, and see you next Sunday.
Depegging of algorithmic stablecoin TerraUSD
Stablecoins are cryptocurrencies that are backed by some underlying asset. Typically, these assets have an expected and stable value, making them “safer” (less volatile) than traditional crypto. Stablecoins fall into four main categories based on the collateral backing them: traditional (off-chain - i.e. fiat), crypto (on-chain - i.e. Bitcoin or other crypto), algorithmic (discussed later), and commodity-backed (i.e. physical assets like precious metals and real estate).
The five largest stablecoins represent $160 billion of value. Three of these stablecoins (USDT, USDC, and BUSD) are issued by centralized entities that keep a treasury of dollars to back their respective coins. DAI is different in that it’s issued by MakerDAO (a decentralized autonomous organization) and is not only backed but overcollateralized by a portfolio of crypto assets. UST is (was) also unique in that it doesn’t have any collateral but keeps its stability through algorithms that are powered by the LUNA token and the Terra protocol.
One of the major news stories dominating the crypto industry over the past week revolved around the depegging of UST. Usually,
“When UST’s price is too high (>$1), the protocol incentivizes users to burn (destroy) LUNA and mint (make) UST. When UST’s price is too low (<$1), the protocol incentivizes users to burn (destroy) UST and mint (make) LUNA.”
And this is exactly what happened when UST’s price started to fall last week. The algorithm began issuing LUNA to the point that it lost 99.9% of its value. In addition to this, the Luna Foundation Guard (LFG), an organization dedicated to supporting the Terra ecosystem, began lending out its stockpiled $3.5 billion in Bitcoin (which it was keeping as a reserve asset for UST). Between these two mechanisms, the stablecoin still failed, making UST and LUNA lose over $40 billion of value.
As I talked about before, only when things go sideways does the system get tested. During these times, we are able to see which projects really do offer value and are able to pull through. UST and LUNA could not, so the bear market claimed another victim. Such a cycle, although vicious, will make the industry stronger in the long-term.
The government & stablecoins
The Fed recently issued its biannual “Financial Stability Report.” Among such topics as large fluctuations in prices of financial assets, excessive borrowing by businesses and households, and high leverage within the financial sector, the report also brought up the potential of stablecoin runs (very timely). It outlined …
“Stablecoins typically aim to be convertible, at par, to dollars, but they are backed by assets that may lose value or become illiquid during stress; hence, they face redemption risks similar to those of prime and tax-exempt MMFs. These vulnerabilities may be exacerbated by a lack of transparency regarding the riskiness and liquidity of assets backing stablecoins. Additionally, the increasing use of stablecoins to meet margin requirements for leveraged trading in other cryptocurrencies may amplify volatility in demand for stablecoins and heighten redemption risks.”
“‘They have the potential to generate destabilizing runs if the value of the assets backing the stablecoin decline abruptly,’ said Liang, who has been leading the Treasury’s work to determine how the federal government should oversee digital assets. She also said that stablecoins may ‘introduce novel risk – payment system risk – related to the distributed ledger technology.’”
Looking at UST, it’s obvious that the risk is not completely unjustified. However, do stablecoins backed by fiat or other assets pose the same type of risk? How does this risk compare to other financial instruments like MMFs? And, should stablecoins be replaced with CBDCs to avoid such risks?
The report doesn't dive deeply into any of these questions, besides voicing its support for CBDCs over stablecoins.
On the other side of the conversation, Senator Patrick Toomey (R-PA) began a discussion around accepting stablecoins as an official part of the financial and banking system. He introduced the Stablecoin Transparency of Reserves and Uniform Safe Transactions Act (“Stablecoin TRUST Act”) which would create one of the most comprehensive and sweeping regulations around stablecoins covering topics such as issuance, disclosure requirements, and exclusion of stablecoins from the definition of “securities,” among others.
All this to say that the government is still undecided over stablecoin regulation, despite the industry needing it (a point I think I’ve underscored one too many times). As US Treasury Secretary Janet Yellen stated during the House Financial Services Committee hearing last week,
"Although I can't say that they've reached the scale right now where they're a financial stability concern, we're seeing Terra having broken the buck and Tether under some pressure as well...I wouldn't characterize it at this scale as a real threat to financial stability, but they're growing very rapidly and they present the same kinds of risks that we have known for centuries in connection with bank runs."
Yellen is right. Stablecoins are not at the point where they pose serious risk to financial stability, which is why we should be happy about UST/LUNA falling now and not in five years. However, stablecoins will eventually get to this point. Whatever the bear market doesn’t weed out naturally, the US government will be responsible for regulating. These regulations need to be well-informed and effective, otherwise the future hits could be destructive and ripple through the rest of the financial industry.