The global regulators saw ripple effects from the collapse of algorithmic stablecoin UST.
The Terra ecosystem’s collapse, which then depreciated its algorithmic stablecoin TerraUSD value (UST), and crashed it to an all time low of $0.30 has cast doubt on the future of all stablecoins.
UST’s stability and success were closely linked with LUNA. This creates arbitrage opportunities which, theoretically, should maintain UST’s price stable. If UST’s value drops below $1, it may be traded for LUNA. This lowers the supply and increases its price.
LUNA can be used to exchange for UST if UST’s value exceeds $1. This creates both a mechanism as well as an incentive to keep the price of UST at $1, provided that everything works properly and conditions are normal.
Although algorithmic stablecoins can’t usually be backed by other assets, the Luna Foundation Guard (LFG), which is responsible for the development of UST and the broader Terra ecosystem has built a war chest with Bitcoin ( BTC) that can be used in the unlikely event that the UST is depegged from US dollars.
If UST’s price drops, traders can borrow the BTC to them. They’ll then use the BTC to purchase UST, pushing it back up and repegging it to a dollar. LFG distributed more than $1.3 billion worth of BTC ( 42,000 Coins at a Price of $31,000 Each) to traders to buy UST. This created demand and boosted its price. But that didn’t stop the ecosystem from collapsing and the spiral effect ultimately led to the collapse of both the LUNA token and its stablecoin.
Even centralized stablecoins like Tether’s USDT lost their dollar pegs in the wake of the collapse. The price of these stablecoins fell to $0.95. Stablecoins are a bridge between various decentralized financial ecosystems. The Terra crash caused high volatility in the decentralized finance markets.
Justin Rice, vice-president of ecosystem at Stellar Development Foundation was skeptical about the future of algorithmic steadycoins after the UST collapse. Cointelegraph was informed by Rice:
“What we are seeing now, and it is not the first time, a positive balancing mechanism unravelling due to natural human reactions to market conditions. It can be difficult to keep algorithmic stablecoins on the right track when market conditions change. You will need to rely upon outside intervention to fix things.
He advocated transparency for stablecoin issuers and third-party audits. Denelle Dixon, Stellar Development Foundation CEO and executive director, hopes that the recent scandal will encourage lawmakers to discuss stablecoin regulations. Cointelegraph was informed by her:
“We have seen significant progress in moving the conversation about stablecoin legislation to the United States. Both sides have introduced bills that are clear and concise and will help move the industry forward. This is a global problem and we recognize that the same rules for stablecoins should be applied to all countries. We are working to bring that consistency to our industry.
All about stablecoin regulations
Stablecoins were a subject of regulatory attention in many major economies for a long time. However, the UST collapse acted to change that. It forced many European, U.S. and South Korean regulators to pay close attention to the weaknesses in these less-stable digital dollars pegs.
U.S regulators are using this incident to push for stricter rules around stablecoins. Treasury Secretary Janet Yellen announced plans for legislation by end of the year.
Yellen stated that it would be appropriate to establish a “consistent federal framework on stablecoins before the end 2022 due to the market’s growth. To pass legislation to create such a framework, she called for bipartisanship from members of Congress.
These could be easily imposed on collateralized safecoins such as USD Coin ( USDC and USDT which are backed and held by a traditional-style Treasury and held by a central entity.
Max Kordek is co-founder and chief executive of Lisk, a blockchain development platform. He believes that lawmakers will use the UST collapse to push for central banks digital currencies (CBDC) after it has been resolved. Cointelegraph was informed by him:
This incident is likely to cause trust in algorithmic stablecoins to be greatly reduced, and it will take a while before this trust is restored. Unfortunately, this will be used as an example by politicians to show why CBDCs are needed around the globe. We don’t require CBDCs. What we urgently need is stable, reliable, decentralized stablecoins.
The Congressional Research Service , a legislative agency, published a report about algorithmic stablecoins that examined the UST crash. According to the research report, the LUNA crash was a “run-like” situation that saw several investors withdraw money from the ecosystem simultaneously.
According to the research paper, these conditions are safeguarded by regulations in the traditional financial industry. However, without regulations, market instability could occur in the crypto ecosystem.
Jonathan Azeroual is vice president of INX’s blockchain asset strategy.
“Algorithmic stabilitycoins backed with super volatile assets are at high risk of a run’ on their funds backing them if investors lose faith in the mechanism designed to ensure its stability value, or if the assets backing them fall below the amount of stablecoin they have issued.”
He believes that the U.S. government is likely to try to increase their control over stabilcoin regulation, since it shows that they are not an answer to a regulated electronic economy. The regulators may require that stablecoins be issued by federally-regulated banks, or that they be regulated as securities. This will allow them to be monitored by the SEC (Securities and Exchange Commission).
David Puth, the CEO of the Coinbase-founded Centre Consortium, hoped that there would be constructive regulations after the collapse of the UST. Cointelegraph was informed by Puth:
“Stablecoins remain a crucial part of the growing crypto ecosystem. Industry organizations in the United States have voiced their desire for clear, constructive regulation.”
Puth hopes for a “thoughtful, pro-innovation regulation that will keep America at the forefront in the blockchain economy.”
South Korea, along with the U.S. is the other nation that has taken stablecoins seriously since the Terra crash. Do Kwon is the founder of Terra and was summoned to the legislature to have a hearing. An risk assessment has been conducted by a Korean regulatory watchdog on various crypto projects that are currently operating in the country.
These are the key lessons
Despite the fact that regulatory discussions about stablecoins are gaining momentum in light of the UST scandal, it has also shown that the crypto market is capable of absorbing a $40 billion loss. The crypto market was able to absorb Terra’s setback without threatening wider market stability.
It is important to note that the market correction and the collapse of Terra have led to a series of second-order effects. These include increased exchange outflows and a spike in liquidations (mostly in derivatives and decentralized financing), a temporary slowdown of DeFi (total value locked and activity have decreased), as well as liquid staking problems.
Cointelegraph spoke with Thomas Brand, Head of Institutions at Coinmotion, a Finnish virtual asset provider.
“Regulators, I presume, are particularly interested in how crypto and stablecoin risks might affect TradFi or CeFi via contagion, (in)direct exposure. These risks have not yet materialized systemically. Regulators might be more attentive to these issues if they find that some stablecoins are reminiscent of shadow banking.
Terra was not considered a systemic threat at this time. However, the effects of its meltdown were limited and could be seen in various interconnected ecosystems.
Cointelegraph spoke with Derek Lim, Head of Crypto Intelligence at Bybit exchange. He explained that although the UST collapse certainly attracted regulatory scrutiny, the crypto market was able to recover without suffering colossal damage. He explained:
“I’d like to highlight that the U.S. regulators raised several concerns about the possibility of a stablecoin-related bank run that could lead to financial instability.” This incident has demonstrated that a bank ran on the third largest stablecoin market cap has not had any impact on the wider crypto markets, much less the S&P.
The Terra spiral disaster highlights not only the need for transparency by stablecoin issuers, but also the importance of a regulated marketplace. Clear regulations would have provided several barriers to small investors losing their funds. Regulators around the globe have already taken notice of this event.
The Terra collapse could be a turning point in stablecoin regulations across the globe, much like Libra’s global stablecoin plans for CBDCs. It may also prompt regulators to accelerate their plans.