With the recent market meltdown in the cryptocurrency markets, the role of stablecoins has come into question, given that they have been anything but their namesake.
TerraUSD (UST), the pioneering project backed by Terraform Labs PTE Ltd., has yet to regain its peg to the U.S. dollar after the price of the algorithmic stablecoin embarked on a freefall earlier this week.
UST now trades at US$0.1627, down more than 66% in the past 24 hours according to CoinMarketCap data. The stablecoin lost some US$16 billion in market capitalization, data showed.
Terraform sought to peg the UST’s against the greenback by backing it against LUNA, a proprietary token. Since UST was an algorithmic stablecoin, the project’s founders sought to rely on incentives instead of a straight dollar peg to keep the stablecoin’s price stable.
See related article: Terra shuts down indefinitely after coming back online; LUNA, UST still on life support
When the price of UST goes above a dollar, LUNA tokens are “burned,” or removed from circulation. According to Terra’s theory, the resulting increase in the supply of UST produced, or “minted,” would help bring the price of a UST back to one dollar.
Conversely, when the UST price fell below a dollar, investors were incentivized to convert it into LUNA tokens, lowering the supply of UST, or “burning” the token and increasing UST’s price because of the scarcity. Both processes offered arbitrage opportunities to investors based on the price differences between UST and LUNA.
But when UST prices slumped, LUNA’s supply surged 20-fold in four days through Thursday, according to analysis by The Block’s Tim Copeland. The supply has since ballooned to 6.91 trillion from 775.69 billion on May 10, according to data from terrascope, a tracker for the Terra Money ecosystem.
LUNA was down 100% in the past 24 hours in late evening trade on Friday Hong Kong time at US$0.00001077. It had reached an all-time high of US$119.18 about a month prior, according to data from CoinGecko.
The Binding of Isaac
In a series of tweets before going radio silent, Terraform CEO Do Kwon indicated that LUNA would be the sacrificial lamb in order to mitigate UST’s free fall.
“I understand the last 72 hours have been extremely tough on all of you — know that I am resolved to work with every one of you to weather this crisis, and we will build our way out of this,” Kwon said on his verified Twitter handle on Wednesday.
Kwon said that the only path forward will be to absorb the stablecoin supply that wants to exit before UST can start to repeg.
“There is no way around it,” he lamented on Twitter.
Kwon said that the increased LUNA supply will be sold on the open market in order to raise funds and rescue the UST peg. Terra is also seeking external capital sources, he added.
With no signs of either approach helping save the stablecoin project, some are questioning the viability of stablecoins themselves, irrespective of a straight dollar peg or not.
“We are in an interesting time … a lot of focus is on how the whole Luna USDT saga will end,” Amber Group’s chief executive officer Michael Wu told Forkast.
“I think a lot of dependencies, general market sentiment, whether the market remains weak or goes even lower from here,” he said. “That will play a factor into how the Luna Foundation will be able to defend the pad.”
His comments come as UST holders took to social media to criticize the stablecoin project, especially Do Kwon, and called for his arrest. His wife even had to seek police protection after an unidentified individual allegedly visited their home in Seoul. Subsequently, Reddit dropped a thread discussing Kwon’s whereabouts.
And though a tale of caution, some industry experts said people shouldn’t forget the first rule of investing irrespective of stablecoins or any other assets.
“It’s very important to do your research and be careful when you invest in this kind of project,” Crypto.com’s Eric Anziani told Forkast. “Overall for the industry, we need to continue investing in terms of research and trying to find right solutions that are decentralized, potentially algorithmic, that can sustain difficult market conditions,” the chief operating officer at the cryptocurrency-exchange said.
Amber Group’s Wu said stablecoins will evolve.
“Personally, I think, if we look over the long term, whether it’s Luna or other algorithmic stablecoins, they will find the path to evolution,” Wu said. “Eventually, I think that will remain to be an important segment of the market,” he added. “But, I think the mechanism, the whole infrastructure to support it will also have to evolve after this.”
See related article: Run on UST cuts the ground from under Terra’s feet
Free for all
The crisis certainly renewed the debate over regulating stablecoins.
U.S. Treasury Secretary Janet Yellen highlighted the risks these coins presented to the financial system and called for regulation.
“A stablecoin known as TerraUSD experienced a run and had declined in value,” Yellen testified before Congress on Tuesday. “I think that simply illustrates that this is a rapidly growing product and that there are risks to financial stability.”
Additional federal regulation was needed to respond to the wave of speculative investment in the currency whose secrecy is an essential part of its appeal, she told the committee, media reported.
“We really need a regulatory framework to guard against the risks,” Yellen said in regard to stablecoins. “Really, we need a comprehensive framework so that there are no gaps in the regulation,” she added, citing the increased usage of digital assets.
Before the fiasco, the Federal Reserve estimated that the value of stablecoins “grew rapidly over the past year,” topping US$180 billion in March. In its Financial Stability Report, it said that though stablecoins typically aim to be convertible, at par to dollars, they are backed by assets that may lose value or become illiquid during market stress, leading to redemption risks similar to those of prime and tax-exempt money-market funds (MMFs).
These vulnerabilities may be exacerbated by a lack of transparency regarding the riskiness and liquidity of assets backing stablecoins, the report said. Increasing use of stablecoins to meet margin requirements for levered trading in other cryptocurrencies may amplify volatility in demand for stablecoins and heighten redemption risks, it added.
The stablecoin sector remained highly concentrated, with the three largest stablecoin issuers — Tether (USDT), USD Coin (USDC), and Binance USD (BUSD) — constituting more than 80 percent of the total market value, the report noted.
In for the long haul
“Oil companies don’t decommission oil rigs overnight based on market fluctuations — it is a long-term commitment,” observed Phil Harvey, CEO of Sabre56, digital asset management consultancy. “Similarly, crypto miners look past short-term peaks and troughs,” he added.
Do Kwon might certainly hope that this is true.
It may not be the end of the road for stablecoins, and certainly not for Terra, Du Kwon opined on Twitter. “Terra’s focus has always oriented itself around a long-term time horizon,” Kwon said. “And another setback this May, similar to last year, will not deter the LUNAtics.”
Correction: A previous version of this story erroneously stated that when UST is worth more than a dollar, LUNA tokens are “burned” or enter circulation.