TerraUSD’s stablecoin meltdown holds the crypto market hostage

There’s red everywhere this week as TerraUSD’s peg to the US dollar snapped, dragging other cryptos with it.

The big crypto news of the week was the rupturing of TerraUSD’s supposed peg to the US dollar. TerraUSD is a so-called algorithmic stablecoin supported by some fancy technology that was designed to maintain its value at $1.

That 1:1 peg broke dramatically this week, with TerraUSD falling to $0.23 before recovering to $0.48 on Friday.

TerraUSD (UST) occupies a subset within the crypto space known as stablecoins, which are a form of cryptos backed by real assets. Most are backed by fiat currencies such as the US dollar, others are linked to metals such as gold. Stablecoins have surged in popularity because their value is stable, unlike Bitcoin and other cryptos which are prone to wild speculative moves.

Read: Crypto-market panic subsides with prices, tether stabilising

The combined value of all stablecoins hit $180 billion in March this year, in part because of a shift out of volatile cryptos not backed by real assets – such as Bitcoin and Ethereum – into more stable assets. Many traders swap their Bitcoin for stablecoins when they expect crypto prices to drop. The reason they opt for stablecoins such as UST is that it is cheaper than switching into fiat US dollars, and they harbour the belief that they are fully redeemable for USD at all times.

Read: More than $200bn wiped off cryptocurrency market in a day

That belief has been shattered this week. Another US dollar-backed stablecoin, Tether (USDT), briefly lost its peg to the US dollar on Thursday, May 12, falling to $0.97 before rallying to $1 – where it should be.

Rumours swirled that the world’s largest asset manager, Blackrock, and hedge fund giant Citadel Securities, had a role in the TerraUSD collapse – rumours that were swiftly denied by the companies.

There was speculation that Blackrock and Citadel had borrowed 100 000 BTC from Gemini, a crypto exchange, swapped 25% of this for UST and then dumped both BTC and UST, causing both to collapse in price, in what has been likened to a George Soros-style attack by Wall Street on the crypto market.

BTC crashed to a 16 month low of $28 600 following the rout, before rallying to $28 600.

Read/listen: TerraUSD plunge spooks crypto market

The interrupted rise of stablecoins

There’s no doubt that stablecoins are here to stay, but the manner in which they are regulated will need closer attention.

The largest of the stablecoins is Tether (USDT), backed 1:1 by the US dollar, and now the third largest crypto by market cap, with a total value of $81 billion.

Just behind USDT is USD Coin, also backed 1:1 by the US dollar, and worth $49 billion.

Then there’s Binance USD (BUSD), the seventh largest crypto by market cap, and worth $17 billion.

All of the above are known a centralised stablecoins, because they operate much like their own central banks, minting and burning coins as demand rises and falls. TerraUSD is decentralised in that multiple players participate in providing liquidity.

Until recently, TerraUSD was the ninth largest crypto with a total market cap of $24 billion. It’s now slipped to 17th place with a market cap of just $5.6 billion.

It operated on an entirely different technology, comprising two separate cryptos: Luna and Terra. This is where the algorithm came into play. TerraUSD was theoretically always worth $1, while Luna, its sibling crypto, has no fixed price. If the value of TerraUSD exceeds $1, the equivalent value of Luna is burned. If TerraUSD dropped below $1 to say $0.98, arbitrage traders would snatch it up and sell for $1 worth of Luna. That was supposed to ensure the UST retained its peg to $1.

An ingenious solution that failed

This is an ingenious methodology for maintaining the peg to the dollar, since it did not require the same amount of capital backing as other “centralised stablecoins”, which are audited to show that they have $1 in real assets (either in fiat currencies, treasuries or other liquid assets). In UST’s case, a piece of computer code maintains the peg.

“Unfortunately, this chink in the Terra network’s design has managed to bring what was a multibillion-dollar project close to zero within days. It also caused systemic risk across DeFi (decentralised finance) and the broader crypto industry,” writes Ahmen Ismail, CEO of Fluid, a DeFi liquidity aggregator.

Paolo Ardoino, Tether’s chief technology officer, says the company has toyed with algorithmic stablecoins, but erred on the side of caution because of the potential for the kind of fallout that hit TerraUSD this week.

“The reason we have always been careful in algorithmic stablecoins was exactly this problem, that if you have assets that are backing this stablecoin, and these assets are subject to heavy volatility, then you are (at) risk of having to liquidate your assets very quickly, and bringing the market even further down,” he told the Wolf of All Streets podcast.

Tether and USDC survived the carnage, and maintained their peg to the USD, though there were arbitrage opportunities between different exchanges in recent days, where Tether was available at less than $1 on crypto exchange Kraken. These could be snapped up and sold on other exchanges for $1, making a 1-2% return for sharp-eyed traders.

As stablecoins hit the $10-$20 billion value mark, the potential for rupture is ever present. Below that level, they are perhaps too small for any kind of sneak attack.

Do Kwon, the CEO of Terraform Labs, the company behind TerraUSD, was reported to be working on a rescue, but it seems certain the stablecoin is doing to have to transition to a more conventional form of asset backing if it is to survive.

Ismail points out that these are the growing pains of a new, and illiquid market. Cryptos are still a tiny part of the broader financial market. There will be more such events. As liquidity improves, volatility will decline. What’s needed to bring some order to this market is regulation – spelling out what a stablecoin is and is not, and where it fits into the financial eco-system, with liquidity aggregators capable of mobilising far larger gobs of capital when needed to prevent this kind of meltdown.

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