The crypto economy is known for seismic price fluctuations. Prices of cryptocurrencies and non-fungible tokens (NFTs), blockchain-based digital assets, can swing wildly throughout the day. But the one asset that’s supposed to remain stable across the crypto ecosystem are stablecoins.
Stablecoins are tokens pegged to the value of a government-backed currency such as the US dollar or commodities such as silver or gold. Tether (USDT) and USD Coin (USDC), the two leading stablecoins, assure buyers of their stable value by promising to hold sufficient assets from the traditional financial system to match the value of outstanding tokens: cash, commercial paper, certificates of deposit, and Treasury bills.
But like all cryptocurrencies, stablecoins are largely unregulated and Tether settled a lawsuit with New York in 2021 over misleading claims about its reserves. Algorithmic stablecoins are even more complicated and, as it turns out, volatile.
Their value is assured not by financial collateral in the traditional markets but by lines of computer code. TerraUSD (UST) is the third-largest stablecoin by market capitalization according to CoinMarketCap and the largest algorithmic stablecoin. To maintain its value, it relies on a separate cryptocurrency called LUNA, which has a variable price. When the price of UST drops below $1, traders can burn UST—removing it for circulation—and raise the price back up. They are awarded the equivalent dollar in LUNA for doing so. But when the price of UST rises above $1, traders can burn LUNA and get the equivalent amount in UST. UST has some collateral in bitcoin, but mostly relies on its algorithm to stay pegged to the dollar.
That system appeared to work until this weekend when a large amount of UST was sold. The price dropped below $1, and then fell further, igniting a mass sell-off, plunging the price of UST to a low of $.25 on May 11, though it has since risen to $.42 as of May 12. LUNA, the linked cryptocurrency, fell precipitously from $116 in early April down to $.0042 at the time of publication. As of May 12, the combined market capitalization of LUNA and UST was $5.5 billion down 88% from the start of the month.
Steven Kelly, a research associate at the Yale Program on Financial Stability, says the fiasco has dashed trust in the promise of Terra’s value. This instability could soon crash entirely, rendering the two coins virtually valueless, and burning tens of thousands of investors in the process.
“It’s 100% a Ponzi,” he said.
What’s the point of stablecoins?
Stablecoins are seen as a safe store of cash without having to interact with the traditional financial system. Holding a stablecoin allows crypto traders to both hold their money entirely on blockchains without being subject to the caprices of market fluctuation. Traders hold stablecoins to easily go in and out of different crypto investments without using a traditional bank or fiat currency.
Gary Gensler, the chair of the US Securities and Exchange Commission, has repeatedly likened stablecoins to poker chips at a casino: You exchange your cash for chips and expect that when you’re done gambling (or trading) the cashier will recognize that your remaining supply has the same exchange rate back to real currency as when you traded them in. The same should be true for stablecoins, though there is no regulatory guarantee, for the most part, that they have the backing assets to pay out customers in case of a bank run (for lack of better terms) or that they will maintain their value peg.
While traditional stablecoins have attracted no shortage of scrutiny—particularly around their lack of regulation, nontransparent asset backing, murky relationships with exchanges, and centralized management—algorithmic stablecoins like USDT make them look like tame investments by comparison. “The assets underlying traditional stablecoins have other purposes,” said Todd Phillips, a former FDIC lawyer who is now the director of financial regulation and corporate governance at the Center for American Progress. “With the algorithmic stablecoin, here Luna, which the other token associated with Terra, its whole reason for existing is to maintain the Terra peg.”
Nevertheless, as UST’s popularity took off, Luna increased in value as well. The coin popped from around $5 in July 2021 to a high of $116 in early April 2022. Now, in the throes of UST’s collapse, Luna is worth a measly $.0042 per coin.
UST is not fully backed by collateral like some stablecoins, but doesn’t rely exclusively on the supply and demand economics of its algorithmic relationship with LUNA. Luna Foundation Guard, the nonprofit in charge of the Terra ecosystem, bought significant reserves in bitcoin. When the nonprofit sold its entire holdings of bitcoin following the crash this week—42,530 bitcoin, or more than $1.3 billion at the time of sale—the price of bitcoin sank to a 16-month low south of $30,000 per coin.
While the UST collapse has spelled trouble for bitcoin, the chaos is somewhat contained, says Yale’s Kelly. With traditional asset-backed stablecoins, like Tether’s USDT, the coin’s management would have to sell real financial assets to pay its customers. “A Tether unwind would ripple beyond the crypto sphere—yes, it undergirds a bunch of crypto trading, but they hold $85 billion of traditional financial assets.” Selling those assets would have “knock-on effects” in the traditional financial world in a way that we won’t see during a Terra sell-off.
US Treasury Secretary Janet Yellen told Congress on May 10 that the Terra debacle reinforces the need for a “consistent federal framework” for regulating stablecoins. President Joe Biden issued an executive order about crypto in March but did not specifically mention stablecoins. Regulators have proposed regulating stablecoins like banks because they take deposits without any insurance that customers rely upon to know their money is protected.
With traditional stablecoins, often compared to money-market funds, regulators also want to know that their operators have sufficient assets to pay out customers in the case of a run on the system.
In the case of algorithmic stablecoins, their operators should have even more reserves than traditional stablecoins, says Eshwar Venugopal, a finance professor at the University of Central Florida. “It should not be [backed] one-to-one,” he said. “It should be over-collateralized because these are inherently more risky.”
Will Terra recover?
Depending on who you ask, algorithmic stablecoins are either a nifty bit of financial engineering or a pyramid scheme propped up by a steady influx of naive speculators. Kelly thinks eventually the bottom will fall out of algorithmic stablecoins once investors grow disillusioned.
“Let’s assume Terra fails. How hard is it to explain?” he says. “It was backed by nothing. People stopped believing in it and the whole thing unwound. It’s a Ponzi.”
Phillips thinks UST will go to zero or close to zero, though it could be salvaged by a wealthy savior. The Panic of 1907, a widespread bank run that started in New York, was only ameliorated by the financier J.P. Morgan, who pledged large sums of his own money. “The run stopped because their dollar deposits were going to have value again because someone was going to come in an recapitalize the banks,” Phillips said. “I don’t think we have anyone like that here. There doesn’t appear to be anyone with the assets or the inclination to back UST up to where UST was before.”
But injecting more cash into the system would not fix the underlying mechanics of the coin if they are inherently flawed.
In recent days, Terra’s operators have attempted to recapitalize UST through a $1.5 billion fundraising push, but those efforts weren’t immediately successful. Terraform Labs, the company behind Terra, halted transactions and restarted Terra’s blockchain on May 12 in an effort to stave off takeover attempts by outside actors. UST is now trading at $.39 and LUNA at $.0199.
Even if UST can inch closer to $1, Venugopal doesn’t think investors will have faith it its stability after this week’s events. “The trust there is gone,” he said. “It may go close to $1 but I don’t think we are going to see the same reputation or widespread use it had before last week.”