Over the weekend, the algorithmic stablecoin TerraUSD (UST) broke its peg. On Monday, it broke it again and has yet to recover. Regulators may need to take a closer look at this particular stablecoin model.
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Very Stable CoinsThe NarrativeTerraUSD, a stablecoin pegged to the dollar, lost its peg twice in recent days and has not regained it since the last decoupling
. Why it mattersThecollapse ofTerraUSD may pose a number of risks, ranging from investors/retailers to institutional investors. Although it is a relatively small cryptocurrency and its impact is relatively limited, it still has some important implications for the sector, especially if it spooks lawmakers or regulators who are already concerned about the collapse of stablecoins.
BreakdownTerraUSD($UST)'s price fell to 23 cents and has a 24-hour high of 92 cents. That would be a normal level of crypto volatility, but the added twist here is that TerraUSD is supposed to be a stablecoin, meaning its price should be 1:1 to the US dollar.
If you are deeply involved in cryptocurrencies and/or have been following this story closely, please go to the "Outside Impact" subsection.
For new readers of this newsletter, or for those who don't normally follow stablecoins as extensively, the idea is that you have a cryptocurrency whose value is stable relative to another asset, like the dollar, and you can then use it as an intermediate unit of exchange or to buy goods and services with crypto without worrying about market volatility.
There are a few ways to achieve this kind of price stability. Stablecoins like Tether ($USDT), USDC ($USDC), and the Binance dollar ($BUSD) are backed by reserves. Issuers say that for every unit of their respective stablecoin in circulation, there is a corresponding U.S. dollar in a bank account.
Stablecoins such as the now defunct Diem (formerly Libra), which was to be issued by an organization founded by Meta (formerly Facebook), would have been backed by a basket of different assets. In the case of the original Libra, this would have been a basket of different currencies.
Algorithmic stablecoins are different. They are not backed 1:1 by dollars, but consist of two tokens: the stablecoin itself and a sister token that is issued (created) or burned (destroyed) as needed to maintain the stablecoin's price.
This sister token (confusingly called Terra, with the ticker $LUNA; I will refer to it simply as Luna for the purposes of this newsletter) can be invested in tools that make the Terra ecosystem more valuable. In theory, USTs should always be redeemable for Luna at the rate of $1 per UST.
According to the Luna Foundation Guard, a Singapore-registered nonprofit designed to support UST price stability, arbitraging trades is one way Luna can be used to maintain its bond.
"Unlike other stablecoins that are backed by fixed deposits of pegged fiat currency or over-collateralization in another DeFi asset, the value of Terra's stablecoin family is maintained through a system of arbitrage incentives, open market trades, and dynamic protocol levers that ensure robust peg stability and supply scalability without the centralized control or capital inefficient designs of incumbents," according to the Luna Foundation Guard website.
Anyway:
Yes, the peg is a bit broken.
It's worth noting that the 24-hour high - 85 cents - means the UST hasn't returned to its peg in more than a day (since Monday, to be exact).
Outside ImpactsA lot ofpeople have lost or are losing money with UST and/or Luna. Institutions are likely in a similar boat, and there are broader market implications as well.
It has been rumored that LFG is seeking up to $1.5 billion in funding to prop up UST's price, while the Guard has lent nearly $1.4 billion in Bitcoin (BTC) for the same purpose.
So I imagine regulators are paying close attention. Treasury Secretary Janet Yellen has already brought up the UST at a Senate Banking Committee hearing representing the Financial Stability Oversight Council (FSOC).
"I would note that there was a report just this morning ... that a stablecoin called TerraUSD has had a run and has declined in value," Yellen told Sen. Pat Toomey (R-Pa.) on Tuesday. "I think that just shows that it's a fast-growing product and there are risks to financial stability and we need a framework."
Toomey himself seems to disagree on the risk aspect, telling reporters Wednesday that USTs are not backed by reserves as fully hedged stablecoins are, and therefore do not pose the same kind of financial stability risk.
Still, what is happening with Luna and UST appears to have some impact on the broader crypto market.
The question is which regulator has jurisdiction over this sector in the first place.
There is an argument that the two tokens could have some securities law implications.
In 2018, a project called Basis raised over $130 million to create an algorithmic stablecoin with a two-token structure, similar to Luna and UST.
The project refunded investors their money after the Securities and Exchange Commission (SEC) warned that the company might be violating federal laws if it did not limit itself to accredited investors.
On a side note, this project was revived in 2020 by some anonymous developers who felt that their anonymity would protect them from regulators. One of these anonymous individuals was none other than Do Kwon, the face of the Terra ecosystem and the founder of Terraform Labs, which originally launched the coins.
In addition, we know that the SEC has Kwon on its radar - officials from the regulator served him with a subpoena during a conference in 2021 regarding Mirror Protocol, another project he is involved in.
Bank regulators, or those charged with overseeing the financial institutions that backed Luna, may also have questions, especially if the companies under their purview suddenly cut back sharply on investments. In addition, there may not be a single federal regulator capable of overseeing some of the institutions that invested in Luna, which could be good or bad depending on whether they lost significant amounts of their investors' money-some of the earlier investors may have realized significant returns when they closed out their positions or sold any equity they acquired in later rounds of financing.
Congress is also likely to take notice at some point.
Ron Hammond of the Blockchain Association said that while stablecoins have been on Congress' radar for some time, all of the bills dealing with this sector of the crypto world have focused on asset-backed stablecoins.
"That has completely changed," he said. "It's changed a lot of conversations."
Algorithmic stablecoins are definitely things lawmakers are paying attention to now, but how they might approach it is unclear.
It will also take some time to figure out exactly what happened, what the risks are, and whether there are additional risks.
This is the kind of situation that could put pressure on Congress, just by the fact that real people are being harmed by this situation.
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