Stablecoins which are cryptocurrencies pegged to a fixed reference have become the main medium for trading of digital assets and NFT’s. The combined supply of stablecoins as of Sept 2021 was $130 billion; a 500% increase from a year ago. However the $49 billion meltdown of the algorithmic stablecoin Terra USD (UST) coin and it’s lined token, Luna this month has shown the shaky grounds on which the lofty valuations of stablecoins have been built. Terra which has fallen in value from being pegged to USD to less than 5 cents and Luna which was one of the top 10 stablecoins in Jan is now worth less than 1 cent. The death of Terra and Luna has also led to a $300 billion decline in the crypto industry.
What are Algorithmic Stablecoins? As noted in a previous post, the pegging of stablecoins to a fixed value is achieved by two main methods; in the more common method the the issuance of the stablecoins is backed up by like for like by cash (USD or other fiat currency) and cash equivalent reserves which is the method followed by the most popular stablecoins like Tether, Binance USD and Coin USD while in the other method the stablecoin issuers maintain the parity using algorithms i.e. combination of overcollateralized cryptocurrencies and smart contracts that automatically defend the parity/peg by buying and selling the stablecoin. Terra USD (UST) was an ‘algorithmic’ stablecoin pegged to the dollar (i.e. 1 UST = 1 USD) by linking it to another cryptocurrency, Luna and used smart contracts to reduce/expand supply of UST to maintain parity to dollar.
How did Terra and Luna work? Buyers of UST could exchange one unit of the token for $1 worth of the related token, Luna at all times. If Luna was worth $100 (as it was on April1st), you could redeem one UST stablecoin for 1/100th of a new Luna, which you could sell on an exchange to get $1. If Luna was worth 10¢, you’d get 10 Lunas for one unit token of Terra USD, UST. To maintain parity of UST with USD, if the price of UST, fell below $1 smart contracts (along with holders of UST) were programmed to swap units of UST for $1 worth of Luna and remove UST from circulation thus reducing supply until the price of UST recovered back to $1. Similarly, if the price of UST rose above $1, the smart contracts removed Luna tokens from circulation to create equivalent, new units of UST and the supply of UST increased until it’s price fell back to $1. This looked good in concept and worked in practice since the Terra Luna ecosystem was started in 2020 as long as price of Luna was increasing. One big factor adding fueling the rise of the Terra-Luna ecosystem was the high yield of 20% offered to holders of Terra USD, UST since March 2021 when Anchor, a quasi-bank for crypto was added to the Terra-Luna ecosystem which let users deposit their Terra stablecoins and earn 20% interest. All of this lead to Luna being worth $116 with a market cap of $40 billion in early April and Terra USD, UST having a market cap of $16B. Now combined market cap of $55 billion of the Terra Luna ecosystem has vanished.
What just happened? On May 7, there was a big redemption of Terra USD when a trader made large swap of Terra USD for rival stablecoins causing its price to drop to 99¢ which prompted speculation that the dollar peg was at risk and redemptions. The next day the redemptions of Terra USD, UST continued and more Luna coins were being added by the algorithm (and UST being taken out) which led to a decline in price of Luna which fell by more than half, to less than $30 and continued losing value the next day. By the morning of May 13, 6.5 trillion Lunas were in circulation, and the price had dropped to $0.00001834. TerraUSD’s price had dropped below 20¢, and while it could still for a huge quantity of Luna tokens worth $1, there was no one to buy them.
What is the history of Algorithm Stablecoins? This is not the first instance of an algorithmic stablecoin expierencing instability during market stress. As shown below, all the algorithmic stablecoins have had a brief life and a sudden death.
The history of the algorthmic stablecoins so far shows that the technology is still nascent and not robust. Essentially the smart contracts and the incentives to limit and increase the supply of the stablecoin to be maintained the peg have broken down in times of stress. Given that there is no collateral and fiat currency backing up these algorithmic stablecoins, there is no floor established that stops the decline of the stablecoins once a run starts on them.
What happens now? This recent round of instability in stablecoins will lead to more calls for oversight over an industry which has shown that it cannot self-regulate. In some sense, the various stablecoins are similar to the various currencies/banknotes in existence before the civil war in the US when different states had different currencies in circulation without any central oversight causing lots of scams and fraud in the notes in circulation. In April, the Acting Comptroller of OCC gave a speech on stablecoins which outlined 2 key reasons why oversight of stablecoins maybe coming sooner.
- regulators need to have oversight of stablecoins to protect people – the biggest supporters of the crypto and majority of the users of cryptocurrencies (and stablecoins) are “young, unbanked and non-whites” who are likely more susceptible to crypto theft or scams. The speech cites the .
- regulating stablecoins is needed to protect the dollar’s status as the world’s’ reserve currency – As all transactions become more digital and stablecoins becomes the primary medium of transaction in the blockchain digital economy takes hold, they could become more attractive than the US dollar and undermine the status of the dollar as the reserve currency of the world.
The Treasury Secretary, Janet Yellen has cited the collapse of Terra and Luna in her speech to the House House Financial Services Committee this month where she mentioned that stablecoins are “growing very rapidly and they present the same kind of risks that we have known for centuries in connection with bank runs”.
These events are happening on the back of the Presidents Working Group on Financial Markets (PWG) report at end of last year which was summarized in another post which concluded that a run on stablecoins in time of crisis as a leading risk to the financial system while acknowledging that stablecoins could support faster, more efficient and more inclusive payments. The PWG report called for Congress to pass laws to regulators have oversight of stablecoin issuers in the same way that they oversee banks, with robust capital requirements and constant supervision. Fed Chariman Jerome Powell has also said in testimony before Congress that stablecoins are “like money funds, they’re like bank deposits and they’re growing incredibly fast but without appropriate regulation”.
The Biden administration has followed up the PWG report with an Executive Order in March on Digital Assets and asked Financial Stability Oversight Council to identify and mitigate economy-wide (i.e., systemic) financial risks posed by digital assets and to develop appropriate policy recommendations to address any regulatory gaps. Some kind of regulatory oversight seems likely over stablecoins but it may not be bad for the stablecoin issuers and could provide stability and confidence which has been shaken up by recent events.