The Stablecoin Crash Explained
The difference between Terra, Luna and Tether and what it means to the crypto market.
Tomorrow on Daily Tech News Show I’ll do a segment explaining the crash of Terra and Tether stablecoins. But here is the full research that will go into that segment.
What Do The Terra, Tether, Luna, Crash Headlines Mean?
While Terra, Luna and Tether sounds like a Neal Stephenson novel it's really more Dickens, a tales of two cryptocurrencies and how they planned for risk.
If you want to understand what's actually going on you need to know a couple of things.
In This Economy?
First, it turns out, there is financial uncertainty out there. Yep. Who knew? And because of that uncertainty, driven by literal war, plague and threat of famine, many people are selling off their riskier assets. One of the riskiest assets is cryptocurrency. So there's a sell-off of Bitcoin, Ether, and pretty much every other cryptocurrency you can think of.
That is not the news. Bitcoin has been through several sell-offs and rebounds. I imagine this one will be no different.
What Is a Stablecoin and Why Doesn’t It Feel Stable?
That brings us to the second thing you need to know about. Stablecoins. The idea of Stablecoins is that they are backed by an actual fiat currency, usually the US dollar. So each dollar stablecoin is exchangeable for one US dollar. The idea is that the coin can be used like a dollar but with the benefit of blockhains and such. All the benefits of cryptocurrency with none of the volatility.
But nothing is ever that simple is it? If you actually hold dollars, they don't go up or down in value. They really are only ever worth one dollar. But if you hold a government bond, or a treasury security, then it's considered as non-volatile as an actual dollar, but it appreciates in value a little. So it’s not smart to hold all your stablecoin reserves in dollars. Keep it diversified and growing a little.
But even if you do that, you still have to buy all those securities which still costs a lot of money if you want to issue a lot of stablecoins. So some folks figured out they could sell people the idea of a simulated backing. They'll guarantee that you can exchange each coin for $1 because they have a rock solid algorithm that will manage the supply and demand of the coins so that they never deviate from being worth one dollar. The algorithm will make sure of it.
Now why would you do this? If you want to hedge against the idea that a lot of people would demand to exchange their stablecoins at once, then you need to have cash and quickly convertible securities on hand. However, if you want to get rich a lot faster and you aren’t worried that people will cash in their stablecoins for actual dollars, because reasons, then you would use the algorithmic method and a lot of hope in momentum. Diamond hands!
Of the coins we mentioned earlier, Luna is backed by an algorithm and Tether is backed by cash and securities.
I wonder which one is in bigger trouble? Let's look.
The Terra Crash
Terra was the 4th-largest stablecoin and maintained by an algorithm. However it wasn't backed by nothing. The Terra folks tied it to a reserve cryptcurrency called Luna. One Terra equaled One Luna. Get it Luna and Terra? Luna was also a cryptocurrency but it was a "reserve" currency that was actually backed by... other cryptocurrencies, including $2.4 billion worth of Bitcoin.
Some of you might uncharitably call this a shell game, but it was a way to bootstrap a stablecoin at considerably less cost than buying billions of dollars worth of cash and securities. And the mix of reserves was diversified such that it would take the entire bottom falling out of the cryptocurrency market to bring down the coin.
Which is what has been happening.
As people began selling off crypto, Luna's reserves, which were diversified but all crypto, started to lose value. As people worried about Luna's reserves, they started to sell off their Luna. As Luna's price dived, it stopped being a useful reserve to back Terra, which caused Terra to dive, straining the algorithm's ability to correct.
On May 10th Luna was at $30.00 per coin.
The next day, May 11th, it was at $1.40 per coin.
It has recently sunk to almost 0.
That of course broke the algorithm's ability to maintain the $1 peg and starting May 9, Terra slid down to about 10 cents.
On May 13th, they halted the Terra blockchain in order to attempt to stabilize the algorithm.
OK, What About Tether?
There's also the story of Tether which has faced the same pressures Terra did, but behaved quite a bit differently.
Tether is backed by a mix of corporate debt, cash and treasury bills. We don’t know how much of each because Tether has not disclosed the exact mix of its assets.
That has been a problem for it.
Back in February 2021, Tether and its backer, Bitfinex, agreed to pay an $18.5 million fine after the New York attorney general investigated allegations that the companies tried to cover up a loss of $850 million. Basically Bitfinixex borrowed money from Tether's accounts to pay someone else, without disclosing that it had done so. New York Attorney General Letitia James’ office claimed it found evidence that Tether sometimes had no reserves.
Tether disputes that, saying there was no finding that Tether issued coins without backing. Which is true. There was no finding, because they settled and agreed to pay a fine for their lack of transparency.
Still, Tether has always been exchangeable for one actual dollar and so far it has stayed that way.
Tether has sounded pretty confident about that. In a May 16th blog post it wrote “Every redemption request which was submitted was redeemed in full.” And also, "Tether engages in constant risk-management and stress-test scenarios, ensuring it always has at hand, a liquid portfolio of assets to manage redemptions, even in a bank-run scenario."
So the sell-off of Bitcoin and other cryptocurrencies did not affect Tether's value. And people did start to panic and sell Tether at one point. People were selling one Tether on the open market to each other (not cashing it in, just re-selling it) for less than one dollar. That's not supposed to happen. Why would I take 95 cents for a Tether when I can cash it in with Tether itself for a full dollar?
You would do that if you were worried that the actual cash and securities backing Tether was not 100% and you wanted to get something out of the coin before there was a run and you got stuck with 10 cents like the people who held Terra.
But Tether hasn't yet defaulted on exchanges and people seem to believe them that they're fully backed, so the panic didn't stick and the trading went back to $1.
And people are definitely cashing out of Tether. On May 11th there was $83 billion worth of Tether in circulation. By May 17th that had fallen $7 billion to $76 billion. Tether made good on $7 billion worth of exchanges.
Is this the 1930s?
In the end these look like bank runs. That's where everybody runs to the bank and withdraws their deposit. If the banks are properly collateralized that can cause defaults as it did in the 1930s. Which is why federal deposit insurance was created. There is no federal deposit insurance for stablecoins. In fact in the US there is no regulation on them at all. At least not yet.
On April 6th, US Senator Pat Toomey proposed the Stablecoin TRUST Act. It would require companies that issue stablecoins to have 100% or more backing of stable coins in cash, cash equivalents or level 1 high quality liquid assets. Level 1 high quality liquid assets are a well-defined financial class made up of reputable government treasury bills bonds or securities. Basically stuff that is easily convertible to cash quickly.
The TRUST Act would also require those assets backing the stablecoin to be publicly disclosed and the stablecoin operator would have to legally attest that the assets do not diverge from that disclosure. The company would also be required to disclose policies for redemption, including turnaround time.
Where We’re going We Don’t Need Laws?
But even without regulation, some see these two stories as an example that the market self-regulates.
The failure of Terra means a poorly-designed project has been eliminated. Yes people who invested in it lost their money but it was not a secret that Terra was a risky investment. And Terra was not big enough to have wider repercussions outside of the crypto market.
That would not be true if Tether crashes. Along with securities and cash, Tether holds corporate debt. If it failed, it would have to dump that debt causing a shock to the wider financial market. And that would be a major problem. But it didn't because it was properly backed. At least for now.
So there you have it. Terra and Luna were a risky system built on momentum and faith in a strong cryptocurrency market, but when that market weakened it collapse. Tether was built with more stability I mind, and while it is not as transparent as maybe it should be, so far it's murky backing seems to be holding.