This week the third-largest stablecoin, Terra (aka UST), with a market cap of $18 billion, lost control of its peg. Its fall to Earth is putting the world of blockchain-based finance at risk.
Stablecoins are designed to be medians of exchange, rather than as speculative assets. They peg a digital token to the U.S. dollar or another asset to provide a reliable value to holders of volatile cryptocurrency. They are intrinsic to protocols for DeFi (decentralized finance), blockchain-based financial services to the crypto ecosystem. This is why there is now about $180 billion worth of high-quality assets backing these instruments.
For a stablecoin to lose its peg is akin to a money-market fund that “breaks the buck” when its share price falls below the $1-price-per-share it is meant to hold. It’s the kind of event that isn’t supposed to happen.
Terra’s problems began in January when its peg faltered, prompting the team responsible for managing its protocol (called the Luna Foundation Guard) to call upon major liquidity providers to raise a warchest of 42,500 bitcoin reserves (valued then at about $1.5 billion).
The biggest stablecoins, such as Tether, USDC and Binance Dollar, maintain their value through reserve backing. Terra is different. It is an algorithmic stablecoin, in which its value is meant to be managed via a second token known as a governance token. Terra’s governance coin is named Luna, hence the Luna Foundation Guard.
The benefit of an algo stablecoin (in theory) is that it doesn’t require capital in the form of U.S. dollar reserves. Instead it relies on a small amount of collateral to grease the wheels of its automated arbitrage mechanism. The algo is meant to manage token issuance and burns automatically, while Terra’s human backers, the Luna Foundation Guard, manage root reserves.
This arbitrage feature is attractive to brokers that offer DeFi services: more than 90 percent of DeFi lending is denominated in stablecoins, according to the IMF. Market makers will make leveraged trades in and out of UST and other stablecoins in order to support positions elsewhere, such as in DeFi lending programs. UST’s own DeFi protocols offer 20 percent annual percentage yield to investors – which is what has driven UST’s market cap.
In extreme situations, the backers of Luna can pledge more collateral to support it – hence the bitcoin warchest accumulated over recent months. But over the weekend, falling bitcoin prices prompted some of Terra’s biggest stakeholders to dump their holdings, creating a downward spiral that so far Terra’s foundation team has failed to staunch.
The damage spreads
Now the risk is becoming systemic. A commentary by Q9 Capital published on Medium on May 10 notes, “The market’s biggest concern is that one of the biggest Bitcoin buyers [staking Terra] will now become a big seller to defend the UST peg.” (Q9 says it has no exposure to UST or the DeFi projects it backs.)
The Terra foundation is hoping to mitigate this by lending out more bitcoin and UST to its biggest market-makers.
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Q9 Capital makes the point that UST is too risky and that other protocols are sounder.
However, the Terra collapse sheds a light on market concentration in DeFi. Most DeFi loans rely on volatile cryptocurrency as collateral, and are frequently liquidated when those coins suffer big swings (hence the demand for stablecoins as lending instruments). Terra could yet impact the wider community.
How intertwined are these market makers? According to the IMF, half of all stablecoin deposits are provided by fewer than 10 accounts. Therefore if a few of them need to withdraw funds to cover losses from a steep decline in the price of bitcoin, they impact liquidity throughout the ecosystem – causing major losses among DeFi retail investors exposed to Terra, and the whales that have been trying to prop it up since January.
Stablecoins act like deposits in DeFi. When more depositors scramble to exit DeFi, it can create a panic akin to a run on a bank. DeFi platforms rely on smart contracts to automatically jack up interest rates to try to keep that liquidity intact.
These arrangements don’t account for market realities such as the highly concentrated number of accounts that provide liquidity, nor the counter-incentive that a George Soros-type of trader could profit from shorting the stablecoin’s peg. Algorithmic stablecoins also assume there is some intrinsic value in their governance tokens – a rather ambitious assumption.
Getting stablecoins “right” is probably the key to enabling blockchain-based finance to realize its potential. It is also important to the development of central-bank digital currencies (CBDCs).
DeFi relies on smart contracts (software executed on blockchain) to automate and decentralize recordkeeping, risk management, collateral management, and other functions that in traditional finance require expensive, manual layers. Important decisions are made by holders of governance tokens in these projects, which is open to anyone (facilitated by the ability to subdivide crypto into tiny portions).
The innovation is therefore compelling: a new infrastructure for financial services that is fast, efficient, accessible, and immune to corruption or rent-seeking by intermediaries.
To function it requires stablecoins to serve as money. They may be used as deposits in DeFi liquidity pools, as assets borrowed from DeFi pools, or as assets used as collateral. Stablecoins are especially useful in the constant leveraging and short-selling activities that DeFi users deploy to take positions on volatile cryptocurrency.
These on-paper constructs face several real-world constraints, including: the concentrated nature of the industry; the volatile nature of cryptocurrency lacking intrinsic value; and vulnerabilities in stablecoin structures (either lack of liquid reserve assets or algos relying on contrived governance coins).
These all contributed to Terra’s swift collapse, which could in turn begin to impair many other positions in the wider crypto market. It also means regulators are going to double down on finding solutions to stablecoins, which could include regulation of DeFi protcols too, where margins against potential losses are lower than in traditional banking because of thin stablecoin reserves.
To date, regulation of DeFi has not been effective because by nature the industry favors anonymity and decentralization, and has gained traction by operating in legal gray zones. However a growing number of regulated financial institutions are now exposed to DeFi via stablecoins. Regulators are therefore looking at stablecoin technical specifications around minting, managing reserves, as even secondary market activity. They could also insist on regulating smart-contract code or audits. Either regulators or the DeFi industry will feel pressure to develop self-regulating standards, through which regulators can monitor DeFi protocols and intervene.
The broader question is to what extent stablecoin reserves operate differently from a commercial bank’s reserves. TradFi reserves are in the form of reserves held at the central bank, and these reserves are the most liquid instruments in the world. A stablecoin’s reserves are in Treasuries or other securities, as well as cash – just as safe as Fed money, but not as liquid.
The Terra collapse is unlikely to stop the growth of stablecoins. It is likely to bring heightened regulation, which may spell the end of algorithmic stablecoins. But this will force the industry and central banks to address even more fundamental questions about money and financial infrastructure.