How A Digital Token Designed to Be Stable Fuelled a Crypto Crash
The latest crypto crash was fuelled by stablecoins, a type of token that’s supposed to hold up when everything else tanks.
The latest crypto crash was fuelled by stablecoins, a type of token that’s supposed to hold up when everything else tanks.
Bitcoin and other cryptocurrencies went from bad to worse as selling pressure spread across the tech landscape. But the latest crypto crash was also fueled by stablecoins, a type of token that’s supposed to hold up when everything else tanks.
Stablecoins are designed to maintain a fixed value, typically at US$1 per token. But a fast-growing “algorithmic” stablecoin called TerraUSD collapsed this past week to a few cents on the dollar. That appears to have shaken confidence in the largest stablecoin, Tether. Prices for Tether, or USDT, dipped to 95 cents for a few hours on Thursday, then rebounded to nearly a dollar.
The episode could shake the foundations of crypto. Stablecoins are the bedrock of trading and lending activities, providing liquidity to individual traders, funds, and market makers on both centralized exchanges and decentralized finance, or DeFi, networks. More than 90% of trading volume in crypto occurs in stablecoins, according to CoinMarketCap. Without stablecoins doing their job—holding their dollar pegs through periods of extreme turmoil—the crypto market may face a loss of confidence, affecting trading activity and prices for tokens ranging from Bitcoin to Dogecoin.
“USDT de-pegging is alarming for all cryptocurrency markets,” says Clara Medalie, research director at Kaiko, a crypto data firm.
This isn’t just a concern for traders and firms in the $1.3 trillion crypto market. Regulators worry that if stablecoins take off as privately issued digital money, they could pose risks to broader markets and monetary policies. A run on a stablecoin could, in theory, lead to heavy selling in assets held as reserves for coin issuers, such as commercial short-term debt. Stablecoins could also substitute for the dollar in international commerce and cross-border payments—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 medium of exchange opened a door for stablecoins to step through. Tether and USD Coin, or USDC, have soared in issuance over the past few years. They’re now worth a combined $130 billion, making them the third- and fourth-largest cryptos, behind Bitcoin and Ether.
“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.
The coins serve numerous purposes: Traders use them to maintain liquidity between transactions and to buy other cryptos; they also play a key role in market-making and are widely used by hedge funds and other proprietary trading firms. Tether, in particular, is the most systemically important; it’s the basis for thousands of “pair trades” on exchanges and DeFi platforms, along with “smart contracts” for lending and borrowing cryptos.
Demand for stablecoins is so high as collateral for trading and borrowing that yields top 8% on many DeFi platforms and centralized sites—and even touched 20% for TerraUSD.
There’s also profit in stablecoins, and it’s attracting banks, payment companies, and fintechs to the space. The bank Silvergate Capital (ticker: SI) aims to revive the stablecoin project originally started by Meta Platforms’ (FB) Facebook, part of a broad push into crypto banking and brokerage products. Visa (V) is offering settlement services in USDC. 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.
Like every other cryptocurrency, stablecoin transactions are recorded on blockchains such as Ethereum. While transaction fees may be steep, the coins are well suited for peer-to-peer transfers that bypass traditional banking systems, cutting out intermediaries. That’s one reason they’re often used for remittances or cross-border payments. Soon after Russia invaded Ukraine, Kyiv began welcoming crypto donations in three tokens, including Tether.
There are basically two kinds of stablecoins: asset-backed and algorithmic. Tether and USDC are the two largest asset-backed coins. The companies backing the coins aim to maintain their pegs by holding reserves equivalent to their outstanding issuance. Every time a dollar’s worth of the coins is minted, the companies are supposed to buy a dollar’s worth of reserves; when the coins are redeemed, those reserves may be sold.
Algorithmic coins like TerraUSD are more complex. They aim to 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. That is supposed to prevent the price of the stablecoin from deviating much above or below a dollar.
TerraUSD relied on a complex mechanism of minting and burning another token, LUNA, to maintain its dollar peg. A cascade of selling in TerraUSD destabilized its peg, however, and crashed prices for LUNA.
Crypto entrepreneur Do Kwon, based in Korea, had tried to shore up LUNA and TerraUSD with plans to purchase up to $10 billion worth of Bitcoin as collateral through the “Luna Foundation Guard.” Before the crash, the foundation held $3.5 billion in Bitcoin.
The selling pressure arose from withdrawals on a DeFi lending protocol called Anchor that offered yields of 20% on TerraUSD deposits. Roughly $14 billion worth of TerraUSD was deposited in Anchor before the crash. Less than $200 million is left.
“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 Guard may be running out of money. Its reserves are down to less than $90 million worth of cryptos, and it holds no Bitcoin in its wallet. The crash also took a toll on the Terra blockchain, which briefly shut down on Thursday “to prevent governance attacks,” according to Terra’s Twitter feed. The world’s largest crypto exchange, Binance, also suspended trading in TerraUSD and LUNA.
Some crypto participants say that while the episode has been painful, it signals that the market is actually functioning. “The market flushed out a weakly designed system, and the speculators that were behind it took a financial hit,” says Ryan Selkis, CEO of crypto data firm Messari.
Yet the crash had contagion effects. Luna’s stockpiling of Bitcoin rippled across other cryptos. Traders expecting a meltdown in TerraUSD appear to have sold Bitcoin, contributing to the token’s declines. That, in turn, weakened demand across crypto markets, which lost more than $400 billion in market cap as scores of tokens declined by more than 20%, including Bitcoin, Ether, Cardano, and Solana.
USDT hasn’t emerged without a black eye, either, underscoring how contagion from one crypto can spread to others and the broader market.
In theory, USDT shouldn’t deviate far from its peg. Tether Ltd., the company backing the token, says USDT is “backed 100%” by reserves at a one-to-one ratio, and promises that investors can always redeem its tokens for an equivalent amount of real money. If a hedge fund were to send the company one million USDT tokens, for instance, the company would send the fund $1 million, even if the price differs on secondary markets.
The token also relies on arbitrage mechanisms with market makers and trading firms to hold its peg. If the price of USDT falls by even a fraction of a penny on exchanges like Coinbase or FTX, institutional traders can buy USDT at a discount and redeem it with the company, profiting off the spread, or difference, to a buck.
Those mechanics do appear to have worked. The coin was at about 95 cents on the dollar at 3:30 a.m. in New York on Thursday, but by 9 a.m. it was above 99 cents.
Why did the price get so low? Overnight selling pressure before banks opened for business may have contributed—leaving a gap between selling on the secondary market and redemptions with Tether. Moreover, Tether redeems tokens only with “eligible contract participants” such as proprietary trading firms, and it isn’t automatic.
Some market participants say USDT’s loss of dollar peg wasn’t a deal breaker for the token. “The market is functioning, and it’s expected to see minor de-risking of other stablecoins following the Terra de-peg,” says John Kramer, director of trading at market maker GSR.
Ouellette, who deals in Tether through his derivatives firm and a separate hedge fund, describes the situation as a “little spooky,” but adds that it looked like typical “arbitrage friction,” exacerbated by hedge funds that had tried to attack USDT and profit off a decline.
Still, Tether hasn’t inspired confidence with its limited disclosures and reserve practices. Based in the British Virgin Islands, Tether issues a periodic “assurance opinion” on its reserves from a Cayman Islands auditor. The last one was from December. In it, Tether said that 84% of its reserves were in cash and equivalents, Treasuries, short-term deposits, and commercial paper. The rest consisted of $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.”
The company said Thursday that it had reduced its holdings of commercial paper by 50% over the past six months, and now holds the majority of its assets in Treasuries.
Still, Tether has run into legal troubles, settling charges last year with New York state and the Commodity Futures Trading Commission over its reserves and disclosure practices.
“Unlike algorithmic stablecoins, Tether holds a strong, conservative, and liquid portfolio,” a Tether spokesperson tells Barron’s. Tether has maintained its stability “through multiple black-swan events” and never refused a redemption, the spokesperson adds. Tether added in a statement that “it is business as usual” and was processing more than $2 billion in redemption requests “without issue.”
The volatility in stablecoins may only build momentum to bring some rules and supervision to the space.
The Biden administration, for one, 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,” though it wouldn’t address algorithmic coins, which are looking far less stable than asset-backed coins.
U.S. regulators and lawmakers have expressed several concerns. One is about the liquidity and quality of issuers’ reserve assets—whether they can readily meet redemption requests in a panic scenario. Another growing concern is contagion to broader financial markets if there’s a run on a major stablecoin like USDT.
Many trading firms hold large amounts of USDT for market-making and liquidity. Those institutions need to be confident that USDT is fully backed and that they’ll be fully repaid in dollars when redeeming large amounts. “I don’t know too many institutional market participants that are concerned about the reserves in Tether,” says Selkis.
Yet if those trading firms were to lose faith in Tether, they may quickly try to sell their holdings on secondary markets. Without a government backstop like the Fed or Treasury Department, USDT would be at the mercy of the market, potentially causing shockwaves to other cryptos and trading at 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.
If anyone might emerge stronger from this, it’s Circle, the company backing USDC. Based in the U.S., Circle says its reserves now consist of cash and Treasuries, fully backing every token.
CEO Jeremy Allaire said on Thursday that the company had issued $1 billion in USDC over the prior 24 hours, which he attributed to a “flight to quality” as investors sought issuers that were fully backed and transparent. “There are others that have chosen not to participate in a regulatory framework,” he said. “Naturally, there are more questions about that.”
Circle, of course, is trying to be a model citizen as it aims to go public. Its revenue model centres partly on generating income from reserve assets and lending activities. Rising interest rates should boost the yield on its reserves. The firm is awaiting regulatory approval for its SPAC merger from the Securities and Exchange Commission. Allaire said he expects the merger to be completed later this year.
Circle probably won’t be profitable for at least another year, though. It’s projecting adjusted operating profits of US$76 million in 2023, assuming that USDC in circulation reaches $190 billion, with 30,000 institutional accounts and $50 billion in lending volume. More shocks to the crypto ecosystem would probably derail those plans, and Circle’s profits.
Reprinted by permission of Barron’s. Copyright 2021 Dow Jones & Company. Inc. All Rights Reserved Worldwide. Original date of publication: May 13, 2022.
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Crypto’s lack of connections with traditional finance means its problems haven’t spilled over to the economy
This year’s crypto collapse has all the hallmarks of a classic banking crisis: runs, fire sales, contagion.
What it doesn’t have are banks.
Check out the bankruptcy filings of crypto platforms Voyager Digital Holdings Inc., Celsius Network LLC and FTX Trading Ltd. and hedge fund Three Arrows Capital, and you won’t find any banks listed among their largest creditors.
While bankruptcy filings aren’t entirely clear, they describe many of the largest creditors as customers or other crypto-related companies. Crypto companies, in other words, operate in a closed loop, deeply interconnected within that loop but with few apparent connections of significance to traditional finance. This explains how an asset class once worth roughly $3 trillion could lose 72% of its value, and prominent intermediaries could go bust, with no discernible spillovers to the financial system.
“Crypto space…is largely circular,” Yale University economist Gary Gorton and University of Michigan law professor Jeffery Zhang write in a forthcoming paper. “Once crypto banks obtain deposits from investors, these firms borrow, lend, and trade with themselves. They do not interact with firms connected to the real economy.”
A few years from now, things might have been different, given the intensifying pressure on regulators and bankers to embrace crypto. The crypto meltdown may have prevented that—and a much wider crisis.
Crypto has long been marketed as an unregulated, anonymous, frictionless, more accessible alternative to traditional banks and currencies. Yet its mushrooming ecosystem looks a lot like the banking system, accepting deposits and making loans. Messrs. Gorton and Zhang write, “Crypto lending platforms recreated banking all over again… if an entity engages in borrowing and lending, it is economically equivalent to a bank even if it’s not labeled as one.”
And just like the banking system, crypto is leveraged and interconnected, and thus vulnerable to debilitating runs and contagion. This year’s crisis began in May when TerraUSD, a purported stablecoin—i.e., a cryptocurrency that aimed to sustain a constant value against the dollar—collapsed as investors lost faith in its backing asset, a token called Luna. Rumours that Celsius had lost money on Terra and Luna led to a run on its deposits and in July Celsius filed for bankruptcy protection.
Three Arrows, a crypto hedge fund that had invested in Luna, had to liquidate. Losses on a loan to Three Arrows and contagion from Celsius forced Voyager into bankruptcy protection.
Meanwhile FTX’s trading affiliate Alameda Research and Voyager had lent to each other, and Alameda and Celsius also had exposure to each other. But it was the linkages between FTX and Alameda that were the two companies’ undoing. Like many platforms, FTX issued its own cryptocurrency, FTT. After this was revealed to be Alameda’s main asset, Binance, another major platform, said it would dump its own FTT holdings, setting off the run that triggered FTX’s collapse.
Genesis Global Capital, another crypto lender, had exposure to both Three Arrows and Alameda. It has suspended withdrawals and sought outside cash in the wake of FTX’s demise. BlockFi, another crypto lender with exposure to FTX and Alameda, is preparing a bankruptcy filing, the Journal has reported.
The density of connections between these players is nicely illustrated with a sprawling diagram in an October report by the Financial Stability Oversight Council, which brings together federal financial regulators.
To historians, this litany of contagion and collapse is reminiscent of the free banking era from 1837 to 1863 when banks issued their own bank notes, fraud proliferated, and runs, suspensions of withdrawals, and panics occurred regularly. Yet while those crises routinely walloped business activity, crypto’s has largely passed the economy by.
Some investors, from unsophisticated individuals to big venture-capital and pension funds, have sustained losses, some life-changing. But these are qualitatively different from the sorts of losses that threaten the solvency of major lending institutions and the broader financial system’s stability.
To be sure, some loan or investment losses by banks can’t be ruled out. Banks also supply crypto companies with custodial and payment services and hold their cash, such as to back stablecoins. Some small banks that cater to crypto companies have been buffeted by large outflows of deposits.
Traditional finance had little incentive to build connections to crypto because, unlike government bonds or mortgages or commercial loans or even derivatives, crypto played no role in the real economy. It’s largely been shunned as a means of payment except where untraceability is paramount, such as money laundering and ransomware. Much-hyped crypto innovations such as stablecoins and DeFi, a sort of automated exchange, mostly facilitate speculation in crypto rather than useful economic activity.
Crypto’s grubby reputation repelled mainstream financiers like Warren Buffett and JPMorgan Chase & Co. Chief Executive Jamie Dimon, and made regulators deeply skittish about bank involvement. In time this was bound to change, not because crypto was becoming useful but because it was generating so much profit for speculators and their supporting ecosystem.
Several banks have made private-equity investments in crypto companies and many including J.P. Morgan are investing in blockchain, the distributed ledger technology underlying cryptocurrencies. A flood of crypto lobbying money was prodding Congress to create a regulatory framework under which crypto, having failed as an alternative to the dollar, could become a riskier, less regulated alternative to equities.
Now, stained by bankruptcy and scandal, cryptocurrency will have to wait longer—perhaps forever—to be fully embraced by traditional banking. An end to banking crises required the replacement of private currencies with a single national dollar, the creation of the Federal Reserve as lender of last resort, deposit insurance and comprehensive regulation.
It isn’t clear, though, that the same recipe should be applied to crypto: Effective regulation would eliminate much of the efficiency and anonymity that explain its appeal. And while the U.S. economy clearly needed a stable banking system and currency, it will do just fine without crypto.
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