Pop goes the weasel
In May 2022, Terra’s Stablecoin (UST) lost its peg to the dollar. In other words, it stopped being ‘stable’. Now let that sink in!! As a stablecoin, UST only had one role, one reason to exist, one destiny to fulfil. And suddenly, that foundational aspect was shaken. Over the next few days, UST fell sharply, bringing down the entire Luna ecosystem with it. Ultimately, it brought down crypto hedge fund Three Arrows Capital (“3AC”) which contributed to the downfall of Celsius, BlockFi, Voyager, and other lenders. Billions of dollars evaporated in quick time.
The world learnt a very valuable lesson that day. Not all Stablecoins are well, stable. As the cryptocurrency market subsequently experienced a downturn, those who have previously criticized the industry started resurfacing with renewed negativity, claiming that it is a highly overrated and fraudulent sector. Most governments trained their regulatory guns with vigour while simultaneously insisting on central bank digital currencies (CBDC) emerging as the natural alternative.
Long story short, Stablecoins stared at a crisis like never before. But before we dart down the rabbit hole here and discuss what led to this, let’s go back to where it started from. Let’s go back to the origin of Stablecoins.
The nature of the beast
The world’s first Stablecoin was BitUSD, and it was released way back on July 21, 2014. BitUSD lost its parity to the US dollar in late 2018, which triggered heavy criticism at that time. Today the most prominent Stablecoins are USDT (Tether) and USDC (Coinbase).
Stablecoins were introduced to bring stability into the crypto world. They are designed to maintain a peg with a fiat (regular) world currency and are thus expected to move up and down in resonance with the said currency. Stablecoins can be of many types, depending on the fundamentals that back their stability. Some are collateralized with fiat world assets while some others are collateralized in the form of other crypto-currencies such as Bitcoin (BTC) or Ethereum (ETH). Still others are collateralized through Gold or Real Estate.
The robustness of any of these coins is generally associated with the asset class that acts as the collateral. So a fiat-backed Stablecoin would have to collateralize actual fiat currency (such as the USD or the GBP) as a prelude to publishing of a Stablecoin of equal value. For stablecoins collateralized through BTC and/or ETH, the need for collateralization is greater; which means $1 worth of a Stablecoin needs to be backed by say, $1.5 worth of BTC or $2 worth of ETH. Finally, there are algorithmic Stablecoins where the stability is maintained through a complex ecosystem of underlying smart contracts. Confusing? you bet. Fallible? Yes, as we witnessed with Terra (UST). But more on that later.
Even though Stablecoin issuers do not guarantee the legal right for users to claim fiat currency in exchange of the coin, it happens in practice as long as the coin is stable. But do you know that there was a time when US Dollar itself was backed by Gold, and anybody who held the dollar could redeem it for Gold at the market price. On August 15, 1971, President Richard Nixon announced the end of dollar convertibility to gold, thus letting the gold price float in the market freely. It’s a fascinating story on why the US Government defaulted on its commitment to redeem its dollars in gold. Heck, there is even a website dedicated to the impact of that decision… check it out at https://wtfhappenedin1971.com
As with any other venture, the issuance of a Stablecoin has to make business sense for the issuer. A Stablecoin issuer generates most of its revenues through two ways:
- Short-term investing in safe assets: You may recall that there is a need for collateralization and that the same should be invested in safe, liquid, and short-term investments like treasuries and money markets. Whilst the interest rate on such products is low (as is the risk), this can become quite lucrative for a Stablecoin with large reserves.
- Issuance and redemption fees: A Stablecoin provider can impose a fee every time a token is issued (fiat money is given to them in exchange for the token) or is reclaimed (the token is given back to them in exchange for fiat currency). This produces income for the provider when there are lots of transactions between fiat and crypto ecosystems. Additionally, issuers may also charge a one-time verification fee for account openings.
Considering the regulatory scrutiny that is now bearing down on Stablecoins, especially after the Terra-Luna fiasco, rest assured that the audit and compliance-related costs are going to increase. Add to that the operational, governance, and marketing-related costs and you have the components of creating the financials for Stablecoin issuance. Not that there are too many people lining up to launch new coins though.
But what do you say to taking chances?
Taking chances with Celine Dion is one thing, getting to dabble with Stablecoins is another. If a stable currency is mythically created out of thin air in what is inherently a very volatile space, then there has to be a risk somewhere. And before we go all Shakespeare and attempt to ‘tame’ the risk, we need to know what we are dealing with. According to renowned investor Naval Ravikant, the Stablecoins are subject to three types of risk – the fraud risk, the censorship risk and the blow-up risk.
- Consider Tether (USDT), the largest of the Stablecoins in circulation today. They claim that for every single Tether that they have issued, they have 1 USD stacked away somewhere safe and sound. But what if they are lying and there is fraud underneath. Not to say there is, but it is the whole trusted third-party model once again, something that crypto was out to overcome in the first place. See the irony here!!
- Consider USDC, which is the token from Coinbase. Coinbase is bound by the laws of the land, and hence tomorrow, the govt. may direct Coinbase to freeze your account and poof.. your Stablecoin reserves suddenly disappear. Unlikely? Maybe. But so was the possibility of US reneging on their promise which happened earlier in 1971 when they demonetized Gold and more recently, when they seized the treasury assets of Russia. Censorship risk is real.
- Then, there are Stablecoins that are (over)collateralized against Bitcoin and Ethereum with the hope that the underlying assets will not sway hugely so that the peg is unimpacted at an aggregate level. Take, for example, Dollar on Chain (DOC) Stablecoin, that is pegged against the USD and collateralized with Bitcoin. DOC’s architecture addresses Bitcoin’s volatility through a complex ecosystem of two other sister tokens, tied through smart contracts. Arguably, this should work. Except if Bitcoin blows up tomorrow, DOC will not have any legs to stand on.
Uses of Stablecoins
Stablecoins are not speculative assets. Instead, they are designed as enablers to support the establishment of Decentralized Finance (DeFi), which is intended to serve the same purpose as traditional finance and offers services like trading, borrowing, and accruing interest on deposits.
Crypto Trading is one such DeFi activity. Now, in an exchange that handles non-crypto assets (e.g. equities), a speculative asset is traded with a more stable currency like the USD. Here USD works both as a ‘medium of exchange’ (means of payment) as well as a Stored Value. Now contrast this with Crypto Trading. If a fiat currency such as USD has to be used here, market participants will encounter inefficiencies resulting from the need to switch back and forth between USD and Crypto. On the other hand, crypto-currencies have inherent volatility which makes them a poor candidate for a medium of exchange. Add the constraint of limited liquidity and none of those can qualify as a stored value. Furthermore, even the most liquid of them all, Bitcoin, has its own issues… transaction costs are very high.
This is where Stablecoins play a key role both as a reliable “medium of exchange” and as a “store of value”. Stablecoins offer a lot of advantages to investors and let them switch from highly volatile digital assets without having to abandon the crypto-space. This is much like a trader of stocks or bonds who may react to extreme market fluctuations by liquidating a portion of their investments to be kept in Treasury Bills until the markets normalise. Being a crypto-currency, a Stablecoin retains all the advantages associated with this ecosystem, such as transparency, instant processing, lower fees, borderless, to name a few. Finally, Stablecoin acts as the go-between medium of exchange in the trade of two illiquid crypto-currencies so that trading does not get impacted for want of liquidity.
Cross-border payment is another use case for Stablecoins. Nowadays, the worldwide mean cost for sending funds across borders is 7%, when we can easily transmit an email or image to any place on the planet with no or minimal cost. Each year, over $550 billion is sent by 250 million migrant workers. While the regular cost of transferring money between two G7 countries can be lower than 2% (which is still quite high), the rate for sending money to or from emerging markets is normally in double digits. This is an ideal use case for Stablecoins as they allow two users to transmit money to each other around the world, instantaneously, 24/7, and with almost no expense.
There are other use cases such as lending Stablecoins to earn interest (just as you do with your savings accounts in banks), raising money through crowdfunding, doing settlements for bilateral OTC trades, and also in areas such as Remittance, Recurring Payments, and funding of Escrow accounts, to name a few.
The UST Meltdown
Now that we have a solid grasp on the world of Stablecoins, let’s explore the explosion of Terra’s Stablecoin (UST). UST failed because of a flaw at the fundamental level. Maybe it was overlooked. Or maybe, the founding team was aware of the flaw but they got greedy and ignored it. Whether it was a hostile attack, as it is assumed that it might be, or it was simply bad design that was exploited, we may never know. But we now have a sense of what exactly happened, and how.
First, we need to understand the algorithm. UST was linked to a sister token, Luna, whose price was set by the market. Because 1 UST was defined as being equal to $1 worth of Luna, that meant that while the amount of Luna handed over in a swap for UST would vary, a holder of $1 in UST would always get $1 in value back. That created arbitrage incentives for traders that were designed to keep the value of UST at or close to $1.
So when UST moves over $1, it was advantageous to swap 1$ worth of Luna with 1 UST and make a profit on arbitrage. Whenever either of them is exchanged, the currency is taken out of circulation by the smart contracts programmed to maintain the system. The scenario above brought more UST into play, thus pushing the price down and closer to $1. When UST moved below $1, the reverse action is triggered that reduces the supply of UST, thus pushing the price up and closer to $1. This was one of the fundamental safeguards to protect the peg. In addition, the Terra network had also bought a portfolio of cryptocurrencies (mostly Bitcoin and Ethereum) for further backing.
The demand for UST was fuelled by a lending framework named Anchor, which promised interest rates as high as 20% on UST deposits, an offer that led to its explosive growth. Now one fine day, there was a huge sale order on UST by a private investor. This coincided with Anchor reducing its rates. These events, happening together, spooked the investors about the prospect of UST, and they started selling. This resulted in what can be termed as a crypto equivalent of a bank run. UST lost its peg to the USD and tanked. The UST-Luna exchange mechanism ensured that this resulted in flooding of the market with Luna, which made Luna prices crash as well.
The crypto reserves were sold to bring the UST back to the peg, but the buying pressure wiped out the reserves very fast. And the rest was history.
Later it was figured out that the private investor had taken a short position on Bitcoin (BTC), and they presumably made a killing as the buying pressure reduced BTC significantly.
The Meta’s Touch
No discussion on Stablecoins can be deemed as complete without the mention of Facebook’s (now Meta) misadventure that lasted for slightly less than 3 years. It was in June 2019 that Facebook announced that they are launching Libra, a global digital currency and financial infrastructure to make cross-border payments easy, cheap, safe, secure, and of course, fast. Libra was meant to be used as a means of payment in everyday transactions and was intended to be used by the retail public.
A non-benefit membership association headquartered in Switzerland, termed the Libra Association, was established and made up of various institutions from all over the world. The Libra Association was touted as the agency where the Libra Reserve would be managed, and the association would be the sole entity that could mint and burn Libra.
To address a global audience, the Libra blockchain was designed to be open source, designed so that anyone can build on it, unlike the closed ecosystems of Facebook, Instagram, or WhatsApp. An open ecosystem was to enable continuous product innovation, thus facilitating frictionless payments for more people. Facebook went as far as deciding to make the Libra Association an autonomous body, with Facebook being just another market participant with their app on the Libra Blockchain called Calibra. They even got the support and backing of stalwarts such as Visa and Mastercard. What could possibly go wrong?
Turns out, a lot. It was the first time that the hegemony of the US Dollar was seriously challenged and with that, the politicians saw red. Facebook was hounded. Visa and Mastercard were threatened and asked to back off. The response from the traditional financial establishment as well was both fierce and negative.
It was but a matter of time before Facebook buckled under pressure and in April 2020, the Libra Association came out with a modified proposal. The global currency announcement was now replaced by single-currency Stablecoins, such as Libra USD, Libra EUR, Libra GBP, and Libra SGD. Each Stablecoin would be fully backed by cash or cash equivalents, as well as short-term government securities denominated in that currency. The Libra Association went as far as saying that if any country develops its own central bank digital currency (CBDC), the same would replace the single-currency Libra Stablecoin for that country.
In December 2020, Libra was rebranded to Diem, which means “Day” in Latin, to denote that it was a new day for the project. In a move for further appeasement, Diem announced in May 2021 a strategic shift to the United States and that it would move Diem’s primary operations from Switzerland to the United States.
Too little, too late!!!! Despite intense lobbying and bending over backward, this was too big a mountain to climb, and in January 2022, Meta abandoned the Diem project, and with that ended the first, serious, organized attempt to challenge the status quo of the monetary sovereignty and policy.
The failure of Diem is a watershed moment not because of its failure to launch but because of the impact it generated. There is no doubt that this acted as a trigger to prompt a wide variety of policy talks, CBDC experimentation, and most notably, a global conversation about the destiny of money. That brings us to the beckoning of CBDCs, but that’s a story for another day.