What we are talking about are stablecoins or crypto tokens designed to stay at a fixed value even if the price of an underlying currency (say Ethereum) changes. As the Ethereum website describes them, stablecoins are basically IOUs for a traditional fiat currency like the US dollar. So, a stablecoin such as USDC or Tether is collateralized against US dollars and its value pegged at $1 for each stablecoin. Cryptographically secured, they were created to serve as a centralized safe haven in the midst of extreme crypto volatility. Their most crucial role, though, is as intermediaries between fiat currencies and cryptos. If you have dabbled in trading crypto, you would know that it is very clunky to use fiat currency all the time; by the time the slow settlement happens, prices can change multiple times. Thus, stablecoins act as intermediate currencies that grease the wheels of crypto exchanges. Some stablecoins have found some interesting off-chain uses. In December, the opposition ‘government’ of Myanmar recognized Tether, the world’s largest stablecoin, as an official currency.
However, the entire ‘stable’ edifice threatened to buckle when the value of one of the world’s largest stablecoins, TerraUSD, with a peak value of $35 billion, collapsed by 95% in a matter of days before it dropped to zero. The Luna Foundation Guard, the governance outfit behind Terra, first tried to shore it up by selling its entire $3 billion reserve of Bitcoin, which in turn pushed the price of the latter sharply downwards. The earth moved beneath the crypto ecosystem, since a large stablecoin like Terra is like a tectonic plate on which much rests. Slight movement away from a $1 peg is manageable, but a collapse could be calamitous.
But why did Terra collapse? And what next? Globally, risky assets have seen a broad sell-off, but there are probably three specific reasons. First, Terra was designed differently from fiat-collateral tokens. It is an ‘algorithmic stablecoin’ backed by nothing more than what the Financial Times calls “the magic of computer code" (on.ft.com/3Gnmntf), with a computer program managing demand and supply. There is a special crypto token called Luna, which was meant to help Terra hold this 1-to-1 peg with the dollar. This is unlike Tether, which is claimed to be fully backed by dollars or government securities. “This whole system is entirely broken because it rests on a speculative asset—Luna—to be the collateral," says Colin Aulds, founder of cryptocurrency storage company Privacy Pros. “The problem is that Luna was created for the purpose of being collateral simply because the Terra ecosystem needed collateral." Second, Terra was offering 19% interest for holding crypto. While some incentive is normal, this high figure smelt rotten from a long way off. Third, Luna was set up by Do Kwon, a founder who called himself “Chief Lunatic". This was not exactly confidence-inspiring.
While Terra clearly was a highly risky outlier, Tether has its own problems. There were close to $82 billion of Tether coins out there and it is highly unlikely that its issuer holds that many dollars as collateral. Tether has been fined by authorities multiple times and has now begun posting financials that show a breakdown of it reserves. However, Tether as well as other big stablecoins like Dai and USDC seem to be holding their $1 price peg, which has given investors confidence that the whole crypto financial system will not crumble. Terra’s founder has proposed a blockchain split as a potential solution, though the cryptosphere is wary.
Top US officials have spoken of the need for regulation. Even as they do this, they should hark back to history. In the America of the 1800s, hunters and cowboys on the frontier had faced a currency shortage. The US had no ‘fiat’ paper currency at the time, only gold and silver coins. But some states let banks print their own notes, redeemable for US coins. Much like stablecoin issuers, a few banks did not bother to hold matching reserves. These banks came to be called ‘wildcats’, perhaps because they had branches in remote areas where wild animals roamed, all the better to deter people from redeeming their notes.
Wildcats seem to be back in crypto avatars, with some of them bolting out of their ‘stable’ doors.
Jaspreet Bindra is the founder of Tech Whisperer Ltd, a digital transformation and technology advisory practice.
