Insight & Analysis

Terra collapse gives currency to crypto fears

Published: May 2022

The collapse of the terraUSD stablecoin has renewed warnings about the volatility that comes with investing in crypto, and also a realisation that stablecoins aren’t actually that stable.

The peg that linked the cryptocurrency terraUSD (UST) to the dollar turned out to be a flimsy one, a peg that snapped and showed that stablecoins aren’t that stable after all.

Stablecoins are supposed to be stable because they are pegged to the US dollar on a one to one basis – ie every stablecoin has an equivalent value in US dollars, and they are supposed to be backed by reserves where the collateral is held in fiat currencies. However, investors – to their dismay – found that what they thought was valued at US$1 hit lows of around US$0.04 when efforts to keep the peg failed, with the depegging wiping millions off their investments.

Other cryptocurrencies – including bitcoin – have also dropped in value, which has added predictions that investors are facing a ‘crypto winter’. Other ‘stable’ coins have also seen their pegs to the US dollar come loose, such as Deus Finance’s DEI stablecoin which has also gone the same way, although the company said on Twitter “Our team is working around the clock to restore the DEI peg”.

Meanwhile Tether, one of the more popular stablecoins, has been paying out to investors more than it actually holds in its cash reserves, according to a report in UK newspaper The Guardian.

These events are just the kind of thing that regulators and policymakers have been warning about, especially the risks that cryptocurrencies pose to retail investors. Sherrod Brown, the Chairman of the US Senate Banking Committee, said that cryptocurrencies need to be regulated and “have the power to impact the rest of the economy”.

The incident has certainly dampened some of the hype that has been surrounding crypto in recent months. There have been calls to make the retail investors good, and crypto enthusiasts have suggested proposals similar to bank deposit protection schemes that would see retail investors reimbursed for their losses.

Terraform Labs, the creator of the UST currency, is registered in Singapore (although it doesn’t have an office there), where the regulator has repeatedly sounded warnings about crypto for retail investors.

Back in January this year, Loo Siew Yee, Assistant Managing Director at the Monetary Authority of Singapore (MAS), said, “MAS strongly encourages the development of blockchain technology and innovative application of crypto tokens in value-adding use cases. But the trading of cryptocurrencies is highly risky and not suitable for the general public. DPT [digital payment token – or cryptocurrency] service providers should therefore not portray the trading of DPTs in a manner that trivialises the high risks of trading in DPTs, nor engage in marketing activities that target the general public.”

This echoes the warnings that the US Federal Reserve has also made about the stability of stablecoins. The Fed’s Banking Stability Report – released this month just as the Terra crisis was unfolding – notes that the current aggregated value of stablecoins grew rapidly in the past year to reach more than US$180bn in March this year.

The report warned of the dangers that stablecoins have, and how their stability may not actually be that stable: “Stablecoins typically aim to be convertible, at par, to dollars, but they are backed by assets that may lose value or become illiquid during stress; hence, they face redemption risks similar to those of prime and tax-exempt MMFs [money market funds]. These vulnerabilities may be exacerbated by a lack of transparency regarding the riskiness and liquidity of assets backing stablecoins. Additionally, the increasing use of stablecoins to meet margin requirements for levered trading in other cryptocurrencies may amplify volatility in demand for stablecoins and heighten redemption risks,” the report stated in its timely warning.

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