Terra Luna
A stablecoin collapses, leading to new calls for crypto regulation
During a few short days last week, the value of the stablecoin TerraUSD and its sister cryptocurrency Luna collapsed in dramatic fashion. Described by insiders as “one of the greatest catastrophies crypto has ever seen”, the failure triggered huge losses in crypto markets and raised new questions about the need for regulation and the role of venture funds in these emerging financial technologies.
Stablecoins: a new type of currency peg
Stablecoins are a type of cryptocurrency that is pegged to a fiat currency. Before its collapse, TerraUSD was a US Dollar stablecoin designed to track USD at 1:1 parity.
Stablecoins are an essential part of the crypto ecosystem. Firstly, they create a bridge which facilitates fiat – crypto transactions more efficiently than would possible through traditional payment methods alone. Secondly, they enable low volatility value storage in crypto, operating as the closest thing the crypto markets have to a reserve currency. However, as in traditional finance, the strength of any currency peg is only as strong as the reserve strategies underpinning it. In the innovative world of crypto, the reserve strategies underpinning price stability – and hence the risk that the peg may fail – vary dramatically between different coins.
Fiat-collateralised stablecoins, such as Tether and True USD are meant to be backed by reserves of the fiat currency itself.
Crypto-collateralised stablecoins, such the DAI stablecoin, are not backed by fiat currency but are instead backed by more volatile cryptoassets such as Bitcoin.
Algorithmic stablecoins, such as Terra, typically hold very few reserve assets but instead manage price through trading strategies.
Terra and Luna fall to earth
Terra’s principal strategy for maintaining the dollar parity of TerraUSD involved a delicate balancing act with a higher volatility sister cryptocurrency called Luna. TerraUSD and Luna were designed to be interchangeable at a price of $1 each: thus if TerraUSD fell below $1, to say $0.99, investors would burn (aka destroy) their TerraUSD to mint (aka acquire) Luna, making a $0.01 profit in the process. This mechanism would (in theory) equalise the supply and demand for the two currencies and ensure that the dollar peg was stable.
However, TerraUSD had became popular amongst crypto investors not because of its fundamental qualities as a stablecoin, but instead because of the opportunity to earn a high rate of interest through a DeFi lending protocol – called the Anchor protocol – which offered an effective interest rate of 20% on TerraUSD holdings. As of 7 May, an astonishing 75% of all TerraUSD was tied up in the Anchor lending protocol (amounting to $14bn, out of a total supply of $18bn).
In March, Anchor announced that it would be moving from a fixed to a floating rate on TerraUSD lending, leading to concerns that the historic 20% rate was not going to be sustained. Over the weekend of 7/8 May, well-informed crypto traders began to withdraw high volumes of TerraUSD from Anchor. Investors burned their TerraUSD en mass, thereby minting exponentially large quantities of Luna, increasing the money supply of Luna by 20 times in just 4 days. This caused hyperinflation, wiping out the value of Luna and making it largely ineffective as a means to secure a currency peg.
The founders of Terra had set aside only small amounts of reserves in other cryptocurrencies – and no fiat reserves - to defend the dollar peg in a worst case scenario. The foundation which held these reserves, the Luna Foundation Guard (LFG), depleted its assets from 80,000 to 313 bitcoins in a largely futile effort to rescue the situation. On Friday 13 May, the major crypto exchanges (including Binance, Coinbase, FTX, Crypto.com, and others) called time on the endeavour by suspending trading in what remained of TerraUSD and Luna.
Shock waves through the crypto markets
The TerraUSD crash hit the wider crypto market hard. Other cryptocurrencies also fell in step, with Bitcoin falling below $30,000 – representing a 56% drop on its all time high of November 2021. It is estimated that over $1trillion in crypto assets were lost in one week as a result of the crash.
Tether, a fiat collateralised USD stablecoin which is the most widely used link between fiat and crypto, lost its dollar peg as investors questioned whether it had sufficient fiat reserves to back the $80bn of supply of coin in issue. At the time of writing, Tether has almost recovered to dollar parity, trading at $0.9988, but has still not revealed details of the fiat reserves it holds to defend the peg in the event of another run.
Concerns have been raised that the speed and scale of market participants betting against TerraUSD may indicate some form of coordinated action from insiders who predicted and profited from this event through an advanced shorting strategy. A number of hedge fund and crypto insiders had previously raised concerns about Terra’s unstable currency peg – leading to the possibility that this may have been a coordinated “Soros style” run.
Concerns have also been as to how the founders behind Terra managed their response to the collapse. In the early stages of the crash, LFG is alleged to have enabled exiting investors to cash out of TerraUSD at a value of $1 (settled in Bitcoin) despite the fact that Luna was already beginning its course of hyperinflation at that time, making losses for other investors inevitable. According to commentators on Twitter, LFG protected the “whales” (the large, well-informed traders in the market) at the expense of less well informed and retail investors.
At the time of writing, Terra has still not released details of the on-chain analytics that would confirm or refute either of these concerns.
Enter the regulators
For several years, regulators in the US and UK have expressed their concern regarding stablecoins. With stablecoins in issue now representing approximately $180bn in assets, and given the essential role that they play in trading and liquidity management between the fiat and crypto ecosystems, they are likely to represent a greater risk to market stability than other cryptocurrencies.
In response to the Terra crash, Treasury Secretary Janet Yellen raised the issue with Congress, explaining of stablecoins that “they’re growing very rapidly and they present the same kind of risks that we have known for centuries in connection with bank runs.” She went on to explain that in light of the growth in this asset class and the inherent risks involved there was an urgent need to pass legislation on stablecoins “before the end of the year”.
There are broadly three areas where regulation – or discussion about regulation – is to be expected.
Firstly, where stablecoins are used as a mechanism to facilitate payments (either as an alternative to fiat payments, or to facilitate fiat-crypto exchange), we can expect them to be regulated in the same way as the payment systems within traditional finance. In the US, a draft Senate bill (termed the Stablecoin TRUST Act) would require any stablecoins used as a medium of exchange to be specifically authorised by US regulators as a “payments stablecoin”. Similarly, in the UK, the FCA has said that they expect most stablecoins to fall within payment services rules.
Secondly, regulators are likely to require greater disclosure of the reserve mechanisms underpinning stablecoins. A separate Senate bill (termed the Stablecoin Transparency Act) would set standards for the “quality of assets held in reserves” as well as requiring stablecoin issuers to report on their reserves. The Bank of England, ECB and BIS all have similar review processes underway.
Thirdly, as retail investments into the crypto ecosystem increase, we may expect to see more aggressive action to ensure that all investors are treated on the same basis and to limit the potential for market abuse. This might include more rules which prevent those with insider information from trading in market, and/or early gates on withdrawals to prevent a situation where well informed investors are able to get out of a run early, leaving others to take the losses. It might also include rules similar to the FDIC principles which govern deposit taking institutions and ensure that all investors can recover up to a reasonable amount – say $100,000 – in the event of an insolvency or run on a stablecoin.
What the Lunasaga demonstrates is that above all else, crypto is currently an almost entirely unregulated market where informational asymmetries and poor disclosure persist. Investors in such markets need to be very careful in assessing the fundamentals on any investments they make. When faced with the next stablecoin or DeFi protocol which appears to defy gravity by offering a 20% interest rate on an asset which supposedly has the risk and volatility profile of the US dollar, investors should remind themselves of the old adage that if something looks too good to be true, it probably is.