TerraUSD’s Price Collapse Shows Vulnerability of Dollar-Pegged Cryptos

TerraUSD, one of the largest stablecoins in crypto, may have escaped a classic bank-run-style death spiral Monday night (May 9) thanks to a massive cash infusion from backers — and a timely trading halt on the world’s largest cryptocurrency exchange.

Stablecoins are increasingly seen as a potential competitor to fiat currencies in the payments market. They bypass many financial intermediaries making payments cheaper and available in or near real time. However, they are generally unwelcome by regulators and central bankers, who see them as a financial threat as the assets that back them are not regulated or, in some cases, even audited — making them particularly susceptible to panic-based runs.

And a run is what happened overnight on May 9 and the morning of May 10.

The dollar-pegged TerraUSD spiraled as low as $0.64 before being propped up by a multibillion-dollar infusion from a foundation set up to protect it from price fluctuations. It isn’t out of the woods, having only reached $0.93 as late Tuesday morning (April 10).

Read more: UST Stablecoin Drops to 92 Cents, Could Jeopardize Funding Algorithm

Indeed, U.S. Treasury Secretary Janet Yellen mentioned the TerraUSD collapse Tuesday morning in a hearing before the Senate Banking Committee as it discussed that report, using it to point out the “risk to financial stability” stablecoins pose.

That stability risk goes beyond runs and the financial chaos that can follow. Ever since Facebook announced plans in 2019 to create an unpegged stablecoin that would be usable for payments almost overnight by its 2.3 billion members, financial experts realized that they could create an entire economy bypassing fiat currencies — one in which they would have few tools to deal with anything from a financial panic to a recession.

That fear has driven the push for central bank digital currencies, which are in many ways being pitched as a way to provide stablecoins’ benefits without giving up control. It has also driven more attention to the need for and capabilities of real-time payments rails like the Federal Reserve’s own FedNow and The Clearing House’s “Real Time Payments” product.

Terrafied traders

TerraUSD, or UST on exchanges, is what’s called an algorithmic stablecoin, a decentralized finance (DeFi) product that pairs a stablecoin with a second, free-floating cryptocurrency that has its supply automatically increased or decreased by the controlling smart contract to encourage an arbitrage process that keeps the stablecoin’s price at $1.

See also: Blockchain Series: What Is TerraUSD? The No. 3 Stablecoin Doesn’t Have a Single Dollar Behind It

In the case of TerraUSD, this is the Terra cryptocurrency, called LUNA on exchanges.

It works like this: Investors can swap one UST stablecoin for $1 of Luna, destroying the UST token and driving down the supply. Any LUNA swapped for UST is also burned. So traders can sell LUNA when the stablecoin falls slightly below $1 and buy it if the price rises above $1, making a profit on the margins.

Until yesterday, LUNA and UST were the No. 9 and No. 10 cryptocurrencies by market capitalization. Now they’re No. 10 (UST) and No. 14 (LUNA).

What happened?

To start with, TerraUSD has begun to lose its dollar peg slowly over the past few days, but only to the extent of a few cents.

It began going off the rails over the weekend after a huge investor started selling UST and withdrew from  Anchor, a DeFi staking protocol that gives high-interest rates for locking UST. As of last week, about three-quarters of the extant UST was locked in Anchor, giving it an outsize influence on the token.

Read more: PYMNTS DeFi Series: What is Staking?

That set up a vicious cycle in which arbitrageurs were incentivized to sell more UST stablecoins for a dollar’s worth of LUNA, driving the price down further. The amount of UST deposits on Anchor dove from $14 billion to $7 billion in 72 hours, CoinDesk reported.

The foundation recently set up to backstop LUNA’s price dumped more than $2 billion worth of bitcoin reserves to shore up the price, with only limited success.

The price of LUNA also began to tank, falling from more than $87 to below $25 yesterday. It’s climbed back to $31 as of Tuesday morning, helped along by the decision of Binance, by far the world’s largest cryptocurrency exchange, to halt trading for five hours due to what it said was “a high volume of pending withdrawal transactions … caused by network slowness and congestion.”

Which is to a say, a run was causing liquidity difficulties and causing more panic.

More problematically, the market cap of LUNA, which was more than $28 billion on May 5, has collapsed to $11.4 billion as its price dropped from nearly $88 to its current mark below $30.

That $11.4 billion market cap is still a big problem, as UST’s market cap is now $16.7 billion — meaning there isn’t close to enough LUNA to back all of the UST tokens.

What’s Next?

The U.S. Federal Reserve warned in Monday’s Financial Stability Report that stablecoins’ “vulnerabilities may be exacerbated by a lack of transparency regarding the riskiness and liquidity of assets backing stablecoins.”

And they were talking primarily about stablecoins backed by a basket of hard assets that might not be liquid enough to meet high demand, exacerbating a run. In the case of an algorithmic stablecoin, the run is also destroying the value of the backing assets.

While it’s not clear if Terra USD will be able to return to parity, it is clear that concerns about the safety of stablecoins in general will be heightened substantially.

The loss of peg of TerraUSD will influence the regulatory scheme that is being set up for stablecoins as part of President Joe Biden’s broader crypto regulation plan. Notably strengthening the hand of those who want stablecoins to be issued only by banks.

See more: OCC’s Hsu: Stablecoins Can Boost Innovation If Regulated Like Banks

At a committee hearing on stablecoins Dec. 14, Sen. Elizabeth Warren (D-Massachusetts) argued that decentralized finance, or DeFi, is “the most dangerous part of the crypto world,” and that stablecoins are “the lifeblood of the DeFi ecosystem,” in calling for far stricter regulations.

Read also: Sen Warren Calls DeFi the ‘Most Dangerous’ Part of Crypto at Senate Hearing

She’ll be more likely to be heard now.