How a Stablecoin Fueled a Crypto Crash


Bitcoin has a reputation as a volatile cryptocurrency. But losses are piling up in a corner of the crypto market that’s supposed to hold up when everything else tanks: stablecoins.

As their name implies, stablecoins are designed to maintain a fixed value, typically set at $1 per token. The biggest ones,


Tether

and


USD Coin,

have held their dollar pegs. But a fast-growing “algorithmic” stablecoin called


TerraUSD

crashed as low as 23 cents on the dollar this past week, before recovering to 72 cents. The declines wiped out more than $10 billion in TerraUSD, plus at least $25 billion in a related token called Luna and its derivatives. It also contributed to a selloff in


Bitcoin

—which itself tanked 25% over the past week.

The Terra meltdown may be an isolated event—confined to tokens that are especially vulnerable to market volatility. But it highlights growing risks as stablecoins evolve and become one of the more controversial areas of crypto.

Regulators worry that if stablecoins take off as privately issued digital money, they could pose risks to broader financial markets and monetary policies. A run on a stablecoin could, in theory, lead to heavy selling in assets held as reserves, such as commercial short-term debt or other cash proxies. Stablecoins could also substitute for the dollar in international commerce and cross-border payments—effectively bypassing banks and making it harder for governments to keep tabs on monetary policies and capital flows.

“The outstanding stock of stablecoins is growing at a very rapid rate, and we really need a consistent federal framework,” U.S. Treasury Secretary Janet Yellen told the Senate Banking Committee on Tuesday, partly in reference to TerraUSD.

Bitcoin’s high volatility and drawbacks as a system for peer-to-peer payments have opened a door for stablecoins. The coins have become a prime medium of exchange for payments, trading, lending, and other activities based on blockchain technology. “Today, stablecoins account for the vast majority of transaction volume in cryptocurrency markets,” says Clara Medalie, head of research at digital assets data provider Kaiko.

While stablecoins represent just 12% of the $1.4 trillion total market cap of cryptocurrencies, they make up a large share of trading volume, according to CoinMarketCap. Demand for stablecoins is so high that yields top 8%—and even touched 20% for TerraUSD.

Once you’re in the ecosystem, stablecoins allow you to act as though you have U.S. dollars, when really you own crypto.


— Stéphane Ouellette

Banks, payment companies, and “fintechs” are muscling into the space. The bank


Silvergate Capital

(ticker: SI) aims to revive the stablecoin project originally started by


Meta Platforms

’ (FB)


Facebook
,
developing its own coin as part of a burgeoning digital-payments exchange.


Visa

(V) is offering settlement services in USD Coin, or USDC, a large stablecoin. The company backing USDC, Circle Internet Financial, is trying to go public via a special-purpose acquisition vehicle, or SPAC, called


Concord Acquisition

(CND). Recent investors in Circle include


BlackRock (BLK)

and Fidelity Investments.

The New Crypto Dollars

Stablecoins are now widely used as de facto dollars in crypto markets. Traders treat them like cash, holding them for liquidity in a digital wallet. They’re also widely used for lending, borrowing, and institutional market-making activities.

“Once you’re in the ecosystem, stablecoins allow you to act as though you have U.S. dollars when really you own crypto,” says Stéphane Ouellette, CEO of crypto derivatives broker


FRNT Financial
.

Other uses include international remittances, or cross-border payments. Soon after Russia invaded Ukraine, Kyiv began welcoming crypto donations in three tokens, including Tether, the largest stablecoin.

Stablecoins also play a key role in providing liquidity and forming the basis of pair trades between cryptos on decentralized-finance, or DeFi, networks. Yet the coins also pose systemic risks on those platforms, says Marcus Sotiriou, an analyst at digital asset broker GlobalBlock. “A lot of DeFi protocols used Terra to park some of their Treasury reserves,” he says. “This will have a large impact on many DeFi protocols.”

Like other cryptos, stablecoins operate on blockchains like Ethereum. They can be transmitted between digital wallets without an intermediary like a bank tracking or processing the transaction. While blockchain transaction fees may be high, the coins are well suited for peer-to-peer transfers that bypass traditional banking systems, cutting out intermediaries.

There are fundamentally two kinds of stablecoins: asset-backed and algorithmic. Tether and USDC are the two largest asset-backed coins—worth more than $130 billion combined in outstanding issuance. The companies backing the coins aim to maintain their dollar pegs by holding reserves equivalent to their outstanding coins. Every time a dollar’s worth of the coins is issued, the companies are supposed to buy a dollar’s worth of reserves; when the coins are redeemed, those reserves may be sold.

Algorithmic stablecoins like TerraUSD are more complex. They generally maintain their pegs through arbitrage and incentive mechanisms involving other cryptocurrencies; when the price deviates from a dollar, traders can profit through a swap with another token also worth a dollar. Ideally, that is supposed to prevent the price of the stablecoin from fluctuating much above or below a dollar.

Could a Stablecoin ‘Break the Buck’? Yes.

While two big stablecoins, Tether and USDC, have maintained their pegs, TerraUSD has been trading well below a buck for days, despite numerous efforts to prop it up.

TerraUSD is backed by the Luna Foundation Guard and crypto entrepreneur Do Kwon, based in Korea. Kwon recently said that Luna would buy up to $10 billion worth of Bitcoin as collateral for TerraUSD. The foundation held $3.5 billion in Bitcoin before the recent meltdown.

The pressure on TerraUSD began last weekend with a $350 million sale of the stablecoin that flooded the market. The pressure accelerated as deposits of TerraUSD on a DeFi platform called Anchor fell by about $10 billion.

“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 Twitter on Wednesday. “As we begin to rebuild [Terra], we will adjust its mechanism to be collateralized.”

Still, the Luna Foundation may be running out of money. Its reserves have dropped to less than $100 million worth of cryptos, and it now holds no Bitcoin in its wallet.

Luna’s stockpiling of Bitcoin created mechanisms for contagion across other cryptos and trading platforms, which clearly couldn’t handle a run on TerraUSD. Traders expecting a meltdown in TerraUSD appear to have sold Bitcoin, contributing to the token’s declines. That, in turn, spread throughout crypto markets, pressuring tokens like Ether and sparking withdrawals from DeFi platforms.

“This is very painful for the Terra ecosystem and might be something it can’t return from,” says Michael Safai, a managing partner at crypto trading firm Dexterity Capital. “At this point, a lot of retail and institutional investors will have lost large sums of money.”

One lesson from this episode is that algorithmic coins now look far more vulnerable to failure than asset-backed coins. Coins “backed by dollars in a bank account or Treasuries are more transparent than an algorithm,” says Stephen Ehrlich, CEO of crypto exchange


Voyager Digital
.
“That doesn’t mean the algorithmic coins aren’t valuable, but there’s more chance for them to lose their peg to the dollar.”

Tether and USDC, however, may have emerged a bit stronger. USDC’s market cap has slipped from $51 billion to $49 billion in the past month as demand for crypto has weakened. But its peg hasn’t broken down. Tether has held up with about $83 billion in issuance and a stable price.

“Algorithmic incentives for stablecoin pegs remain an unsolved problem,” says Adil Abdulali, head of portfolio management at Securitize Capital, in a commentary. “Old-fashioned, reserve-backed stablecoins such as USDC continue to be the only viable digital dollars we work with.”

Stablecoin Rules Are Coming

Crypto regulation is gaining momentum worldwide, and stablecoins look like the low-hanging fruit. U.S. regulators and lawmakers have expressed several concerns about the tokens. One is about the liquidity and quality of issuers’ reserve assets—whether they can meet redemption requests, especially in a panic when millions of people try to redeem their coins at once.

Tether has been opaque about its holdings. The company, based in the British Virgin Islands, issues a quarterly “assurance opinion” on its reserves from a Cayman Islands auditor. More than 80% of its reserves were held in Treasurys, cash, certificates of deposit, and money-market funds at the end of December, according to the report. But details are scarce about the rest, including $4.1 billion in “secured loans”; $3.6 billion in “corporate bonds, funds, and precious metals”; and $5 billion in “other investments,” including “digital tokens.”

Tether’s disclosures and reserve quality have improved, albeit with regulatory prodding. Tether and its affiliated corporate entity, Bitfinex, settled charges brought by the New York state attorney general over its reserve and disclosure practices last year. Tether also paid a $41 million fine to the Commodity Futures Trading Commission for allegedly misstating its reserves.

“Unlike these algorithmic stablecoins, Tether holds a strong, conservative, and liquid portfolio,” a Tether spokesperson told Barron’s. Tether has maintained its stability “through multiple black swan events” and never refused a redemption, the spokesperson added, noting that Tether’s reserves are published daily and have improved with a reduction in its commercial paper holdings.

Circle, meanwhile, is trying to be a model crypto citizen. The company says its reserves now consist of cash and short-term U.S. bonds. Circle also aims to become a “full-reserve digital currency bank,” operating under the supervision of the Federal Reserve and other U.S. regulatory agencies. “We want to be a full reserve bank and hold cash or Treasuries with the Fed,” CEO Jeremy Allaire said in a recent interview with Barron’s. “There’s a huge amount of risk management that’s already in place.”

The Biden administration, for its part, wants coin issuers under federal supervision, potentially even carrying FDIC deposit insurance. Biden called on Congress to pass supervisory rules for stablecoins in a recent executive order on crypto.

Congress is also working on a variety of rules for stablecoins; a draft bill in the Senate would establish a process for banks and credit unions to issue stablecoins, among other measures. Sen. Patrick Toomey (R., Pa.) recently introduced a framework for regulating “payment stablecoins,” but it wouldn’t address algorithmic coins, which are looking far less stable than asset-backed coins.

One concern is that crypto exchanges hold large amounts of Tether for market-making and trading liquidity. If Tether were to lose its peg, triggering a run on the stablecoin, it could spill over into other crypto trading, which in turn could affect crypto brokerages from


Coinbase Global

(COIN) to


PayPal Holdings

(PYPL).

“If you’re a regulator, I think what they’re worried about is not that the crypto community goes poof; it’s that the losses at Coinbase then feed to PayPal and then feed to a bank,” says Bryan Routledge, a professor of finance at Carnegie Mellon University.

Investing in Stablecoins

Stablecoins aren’t like Bitcoin or other cryptos with explosive growth potential. But banks and other firms are building a business model around them, and there are ways for investors to try to capitalize.

Lending your coins is one such option. Several centralized platforms offer high yields for “accredited investors”—those with at least $200,000 in annual income or a $1 million net worth. They include Celsius Network and BlockFi. Other lending platforms include DeFi networks like Aave and Compound. The Securities and Exchange Commission and other financial regulators have raised concerns about crypto lending, however, and recently shut down BlockFi’s lending products for retail customers.

Crypto bank Silvergate is another option. While the company hasn’t launched its stablecoin, it’s developing an institutional digital exchange network for hedge funds, brokerages, and other firms. Wall Street loves the stock—it’s rated a Buy by eight out of nine analysts covering it, with an average price target of $204, nearly triple its recent price of $71.51.

Another equity play is the Circle SPAC through Concord Acquisition. Circle raised $400 million in a recent funding round and valued itself at $9.5 billion, including debt. The deal is awaiting regulatory approval.

Alongside earning a yield on its reserves, Circle’s business centers on cryptocurrency trading as a market maker on exchanges and other markets. Rising interest rates should boost the yield on its reserve assets.

The company has never turned a profit, according to its registration statement. It’s projecting adjusted earnings before interest taxes, depreciation, and amortization, or Ebitda, of $76 million in 2023. That assumes that USDC in circulation reaches $190 billion, with 30,000 institutional accounts and $50 billion in lending volume.

Concord trades around $10, equivalent to its cash-out value if the SPAC merger falls apart. The stock is off 26% from its 52-week high. It may be a sign of weaker demand for crypto and skepticism that the SEC will approve the deal. USDC may also have to prove itself stable enough to withstand more shocks to the crypto ecosystem.

Write to Jack Denton at jack.denton@dowjones.com



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