Stabilising stablecoins: What can we learn from the collapse of TerraUSD?
This article was originally published by Digital Pound Foundation
In May 2022, TerraUSD (UST) – previously the third-largest stablecoin with a market cap of USD $18+ Billion – lost its peg to the US Dollar, falling almost 95 percent within a matter of days. In this article, we look at the circumstances surrounding UST’s spectacular collapse, and the effects of its contagion on the crypto markets. We then look ahead, to understand the tools that central banks and regulators can use to improve consumer protection and systemic stability, and to decrease the potential for market abuse, whilst ensuring that innovation in the still-nascent and evolving digital currency space is not unduly stifled. But first, let’s start with the basics – what are stablecoins? How do they function, who uses them, and for what purposes are they used?
What are stablecoins?
Stablecoins are digital tokens that are ‘pegged’ to one or more reserve assets. We’ll go through the different ways in which stablecoins can be pegged in more depth; however, fiat currency-backed stablecoins are but one flavour. The two most popular stablecoins, at present, are Tether (USDT) and USD Coin (USDC), both of which are US dollar-denominated, and both of which claim to be backed by reserve assets (not limited to USD), having a value that approximates the underlying USD notional value. USDT and USDC are mainly used by cryptocurrency investors and traders, both as a means of settlement for crypto transactions on-ledger, and as a means of holding value in a fiat currency without cashing out their positions on a crypto exchange. Stablecoins present key benefits to those operating within the cryptocurrency markets – and beyond – primarily:
Managing volatility risk – The value of cryptocurrencies like Bitcoin and Ether fluctuates a lot — sometimes by the minute. The ability, in times of volatility, to hold value in an asset that’s pegged to a more stable currency can give buyers and sellers greater certainty that the value of their positions won’t rise or crash unpredictably in the near future.
Sending or receiving funds and transmitting value – You don’t need a bank account to hold stablecoins, and they’re easy to transfer. Using stablecoins as a means of transmission, value can be sent easily around the globe, including to places where the U.S. dollar may be hard to obtain or where the local currency is unstable. Fast processing times and low transaction fees make some stablecoins a good choice for sending money anywhere in the world. People have sent as much as a million dollars worth of USDC with transfer fees of less than a dollar.
Four types of Stablecoins
The world of stablecoins is a new and diverse one, and one that is subject to constant experimentation and evolution. At present, stablecoins can be roughly grouped into four different types, or ‘flavours’ – based on characteristics such as the nature of the underlying asset or assets, the mechanism by which their value is calculated and ‘pegged’, and the type of reserves or collateral held by their issuer:
Fiat-backed stablecoins – These derive their value from a peg to one or more underlying fiat currencies. For every coin in circulation, the issuer must hold the equivalent value in cash or other assets in reserve, in order to maintain its peg. Popular examples include Tether (USDT) and USD Coin (USDC), which maintain their peg to the US Dollar by holding cash, cash equivalents, treasury bonds, commercial paper, corporate bonds, or certificates of deposit with foreign banks. These single-currency Fiat-backed stablecoins are currently used as both a means of payment and a store of value, as we’ve seen.
In some jurisdictions, such as the UK and the EU, a single-currency Fiat-backed stablecoin may already fall within the scope of existing regulation (for the UK / EU, this would be the E-Money regime), with multi-currency-backed coins projected to come into scope in the near future. In others, they do not yet fall within the scope of any regulatory regimes beyond AML / KYC requirements.
Commodity-backed stablecoins – Less common than other forms of stablecoins, these are backed by commodities such as oil, gold, and other precious metals. The value of the stablecoin will rise and fall, in fiat terms, depending upon how the underlying asset performs in the markets. These stablecoins can therefore be seen as an investment vehicle rather than a means of minimising volatility.
In some jurisdictions, and depending on the way in which these are structured, Commodity-backed stablecoins are currently regulated in the same way as securities or other financial instruments.
Crypto-backed stablecoins – Each coin is pegged either to the value of a single cryptocurrency, such as Bitcoin with Wrapped Bitcoin (wBTC), or pegged to a fiat currency but collateralised with cryptocurrency. With respect to the latter, the value of the cryptocurrency collateral is typically required to be higher than that of the pegged asset, in order to manage volatility. An example is DAI, which is soft-pegged to USD and collateralised by a range of Ethereum-based cryptoassets. These stablecoins are used for much the same reasons as Fiat-backed stablecoins: hedging, speculation, payments and as a store of value.
At present, Crypto-backed stablecoins do not fall into the regulatory perimeter in any jurisdiction.
Algorithmic stablecoins – Algorithmic stablecoins, unlike other types of stablecoins, are not backed by assets at all. Instead, their value is controlled by an algorithm that manages the amount of the coin in circulation such that its value remains pegged to an underlying asset. The most popular, and now notorious, algorithmic stablecoin is Terra USD (UST), which is pegged to USD through an algorithmic relationship with the cryptocurrency Terra (LUNA). When the price of UST loses its peg to USD, traders are incentivised to swap between UST and LUNA, burning one for the other (essentially arbitraging the slip in the peg), which either increases or decreases the supply of UST in the market – and thus its value, maintaining the USD peg over time.
At present, Algorithmic stablecoins are also unregulated.