Regulators anxious 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 increasingly concerned about stablecoins following the collapse of controversial cryptocurrency firm Terra.

TerraUSD, an “algorithmic” stablecoin intended to be pegged one-to-one with the US dollar, erased much of its value this week after a stunning run in the bank that saw billions of dollars suddenly evaporate from its market value.

Also known as UST, the cryptocurrency worked using a complex code mechanism combined with a floating token called luna to balance supply and demand and stabilize prices, as well as a stack of billions of dollars worth of bitcoin.

Tether, the world’s largest stablecoin, also fell below the target $1 for several hours on Thursday, fueling fears of possible contagion from the fallout from the UST de-pegging. Unlike UST, tether is assumed to be backed by sufficient assets in a reserve.

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

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

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

Yellen urged Congress to approve federal regulation of stablecoins before the end of this year.

The British government is also taking note. A government spokesman told CNBC on Friday that it stands ready to take further action against stablecoins following the collapse of Terra.

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

Britain plans to bring stablecoins within the scope of electronic payments regulations, which would allow issuers such as Tether and Circle to come under the scrutiny of the country’s market watchdog.

Separate proposals in the European Union would also put stablecoins under strict regulatory scrutiny.

What are stable coins?

They are a kind of casino chips for the crypto world. Traders buy tokens like tether or USDC with real dollars. The tokens can then be used to trade bitcoin and other cryptocurrencies.

The idea is that when someone wants to cash out money, they can get the equivalent amount of dollars for however many stablecoins they want to sell. Stable coin issuers aim to hold sufficient funds to match the number of tokens in circulation.

Today, the entire stablecoins market is worth more than $160 billion, according to data from CoinGecko. Tether is the world’s largest, with a market value of approximately $80 billion.

What happened to UST?

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

Instead, UST relied on a system of algorithms. It went something like this:

  • The price of UST may fall below a dollar if there are too many tokens in circulation but not enough demand
  • smart contracts – lines of code written into the blockchain – would kick in to take the excess UST from supply and create new units of a token called luna, which has a floating price
  • An arbitrage system was also in play, encouraging traders to take advantage of deviations in the price of the two tokens
  • The idea was that for one UST you could always buy $1 worth of luna. So if UST was worth 98 cents, you could essentially buy one, trade it with luna and make 2 cents in profit.

Luna, the sister token to UST, is now essentially worthless after surpassing $100 per coin earlier this year.

The entire system was designed to stabilize UST at $1. But it collapsed under the pressure of billions of dollars in liquidations — especially 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 concerned?

The biggest 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 a portion of its assets in Lehman Brothers commercial paper (short-term corporate debt). When Lehman went bankrupt, investors fled.

Earlier, Tether said its reserves were made up entirely of dollars. But it reversed that position after a 2019 settlement with the New York Attorney General. Disclosures from the company revealed it had very little cash, but a lot of unidentified commercial paper.

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

“We expect recent developments to lead to increased calls for regulation of stablecoins,” rating 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 creditworthiness of the companies issuing them, Fitch says.

“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 impacted if crypto 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 assets fall sharply. Nevertheless, we generally consider the risks to Fitch-rated issuers and real economic activity to be very significant. low.”

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