MODERN FINANCE: A Not So Stable Stablecoin

MODERN FINANCE: A Not So Stable Stablecoin

By Philip Dudley

Philip Dudley

The last few weeks have been extremely challenging for investors in Stablecoins, otherwise known as cryptocurrency where the price is designed to be pegged to a cryptocurrency, fiat money, or to exchange traded commodities. Enter TerraUSD, its sister company Luna and a quasi-bank run.

TerraUSD, also known as UST, has temporarily crippled the ambitions of the world of modern finance. This is not about some Russian hack or dark pool scheme but rather an algorithmic Stablecoin that broke its peg to the dollar and subsequently collapsed in a matter of days.

Let me explain.

A parallel financial system has been emerging in recent years where people invest and trade in cryptocurrencies, but also need to maintain a link to government backed currencies to pay the rent or purchase a durable good. Stablecoins, as an asset class, bridge this divide and act like a “reserve currency” as long as everyone understands its value. As recently as the first week in May, there was $180 billion of value.

The simplest and safest of Stablecoins will hold $1 of Treasury bills for every 1 Stablecoin created. Not so for TerraUSD because it has an algorithmic approach that relies on financial engineering to maintain its peg to the dollar.

This story doesn’t end with the algorithm blowing up, but rather starts with TerraUSD being lent out for 20% interest from a related entity known as Anchor Protocal. Anchor is a crypto bank, and in a matter of days there were several large withdrawals of UST which spooked the market and triggered the collapse. This was the quasi bank run, with nearly $14 billion of UST withdrawn from Anchor and sold in a matter of days.

Was this the work of a short seller … maybe?

Luna is the sister coin to TerraUSD and was supposed to serve as a backstop when UST either climbed above or fell below $1 by “burning” or “creating” coins to control the supply.

This system only works if people want Luna. In the moment of maximum stress created by the sudden withdrawal and sale of TerraUSD, no one did, and Luna collapsed, wiping out $20 Billion.

Making matters even worse for the faithful was a so-called final line of defense being wiped out. Luna Foundation Guard, founded by TerraUSD founder Do Kwan, deployed $3 billion of Bitcoin (contributing to its decline) in an attempt to backstop the peg, and failed.

And so, in the end, the exit door was the only thing that mattered.

The silver lining in all of the wreckage is the relative outperformance of Bitcoin. TerraUSD’s collapse should bring more regulation of crypto in general and Stablecoins in particular. With regulation, the strong companies will become stronger and Bitcoin should take market share in the world of cryptocurrencies as the grandfather of them all.

Still, be careful out there. Not many institutions can survive a haircut of this size.