Regulators Concerned About Stablecoins Like Tether After UST Collapse

The entire stablecoin market is now worth over $160 billion.

Justin Tallis | AFP via Getty Images

Regulators are growing increasingly concerned about stablecoins following the collapse of controversial cryptocurrency venture Terra.

TerraUSD, an “algorithmic” stablecoin that was supposed to be pegged to the US dollar, erased much of its value this week after a staggering run on the bank that saw billions of dollars suddenly evaporate from its market value.

Also known as UST, the cryptocurrency operated using a complex code engine combined with a floating token called a luna to balance supply and demand and stabilize prices, as well as a multi-billion dollar stack of bitcoin.

Tether, the world’s largest stablecoin, also dropped below $1 for several hours on Thursday, stoking fears of possible contagion from the fallout from the UST unlink. Unlike UST, tether must be backed by sufficient assets held in a reserve.

US Treasury Secretary Janet Yellen directly addressed the issue of UST and tether “breaking the ball” this week. At a congressional hearing, Yellen said these assets do not currently pose a systemic risk to financial stability — but suggested they eventually could.

“I wouldn’t characterize it on this scale as a real threat to financial stability, but they are growing very rapidly,” she told lawmakers on Thursday.

“They present the same kind of risk that we’ve known for centuries with bank runs.”

Yellen has asked Congress to pass federal regulation of stablecoins by the end of this year.

The UK government is also taking notice. A government spokesperson told CNBC on Friday that it is ready to take more action on stablecoins following the collapse of Terra.

“The government has made it clear that certain stablecoins are not suitable for payment purposes as they share characteristics with unbacked cryptocurrencies,” the spokesperson said.

Britain is planning to bring stablecoins within the scope of electronic payments regulation, which could make issuers such as Tether and Circle subject to oversight by the country’s market watchdog.

Separate proposals in the European Union would also bring stablecoins under strict regulatory oversight.

What are stablecoins?

They are like casino chips to the cryptocurrency world. Traders buy tokens like tether or USDC with real dollars. Tokens can be used to trade bitcoin and other cryptocurrencies.

The idea is that whenever someone wants to make a profit, they can get the equivalent amount of dollars for as many stablecoins as they want to sell. Stablecoin issuers must maintain a sufficient level of cash corresponding to the number of tokens in circulation.

Today, the entire stablecoin market is worth over $160 billion, according to data from CoinGecko. Tether is the largest in the world, with a market cap of around $80 billion.

What happened to the UST?

UST is a unique case in the world of stablecoins. Unlike tether, it had no real money to back its supposed peg to the dollar – although at one point it was partially backed by bitcoin.

Instead, the UST relied on a system of algorithms. It happened more or less like this:

  • The price of UST can drop below a dollar when there are too many tokens in circulation but not enough demand.
  • smart contracts – lines of code written on the blockchain – would go into action to eliminate excess UST and create new units of a token called luna, which has a fluctuating price.
  • There was also an arbitrage system in play, where traders were incentivized to profit from deviations in the price of the two tokens.
  • The idea was that you could always buy $1 in luna for a UST. So if UST was worth 98 cents, you could essentially buy one, trade it in for luna and pocket 2 cents in profit.

Luna, the sister token of UST, is now basically worthless after having surpassed $100 per coin earlier this year.

The entire system was designed to stabilize the UST at $1. But it collapsed under the pressure of billions of dollars in liquidations — particularly on Anchor, a lending platform that promised users interest rates of up to 20% on their savings. Many experts say this was unsustainable.

Why are regulators worried?

The main fear is that a major stablecoin issuer like Tether could be the next to experience a “run on the bank”.

Yellen and other US officials have often compared them to money market funds. In 2008, the Reserve Primary Fund – the original money market fund – lost its net asset value of $1 per share. The fund held some of its assets in commercial paper (short-term corporate debt) of Lehman Brothers. When Lehman failed, investors fled.

Previously, Tether said its reserves consisted entirely of dollars. But it reversed that position after a 2019 settlement with the New York attorney general. Company disclosures revealed it had very little cash, but lots of unidentified business paper.

Tether now says it is reducing the level of commercial paper it owns and increasing its holdings of US Treasuries.

“We expect recent developments to lead to an increase in calls for regulation of stablecoins,” ratings agency Fitch said in a note on Thursday.

While the risks of stablecoins like tether “may be more manageable” than algorithmic ones like UST, it ultimately comes down to the credibility of the companies issuing them, according to Fitch.

“Many regulated financial entities have increased their exposure to cryptocurrencies, defi and other forms of digital finance in recent months, and some Fitch-rated issuers could be affected if cryptocurrency market volatility becomes severe,” the company said.

“There is also a risk of an impact on the real economy, for example through negative wealth effects if crypto asset values ​​fall sharply. However, we view the risks to Fitch-rated issuers and real economic activity as being generally very low”.

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