The Terra LUNA collapse: 6 questions to demystify stablecoins
Many investors would have heard about the recent dramatic collapse of the Terra USD stablecoin peg which led to the loss of US$16 billion of investor capital.
While this event triggered a large spike in investor fears over digital assets, the problem related specifically to Terra and its sister currency Luna rather than the broader digital asset market.
Unlike traditional stablecoins, which issue currency tokens pegged to real financial assets (like US dollars or bonds held in a bank account), Terra USD relied upon an algorithmic equation. As volatility spread across fixed income, equity and digital asset markets, the algorithmic peg broke and US$16 billion of Luna assets disappeared within a week (Figure 1, below).
Figure 1 – Terra (LUNA) price, in USD
But while Terra’s collapse might be an isolated incident, the largest stablecoin USD Tether has also had significant issues.
Many investors are still in the dark about what stablecoins are, their true risks, and their amazing potential to revolutionize global payments and banking.
Below we look at 7 key investors questions to demystify stablecoins and explain why Terra and Tether are in difficulty.
1. What are stablecoins?
Most stablecoins are simply digital versions of fiat money. In cryptocurrency markets, they allow investors to easily swap from digital tokens to digital cash without paying the high fees of the fiat banking system. They act like money market funds that provide liquidity into traditional debt markets. Their long-term potential, however, offers enormous potential to completely transform current payment systems.
2. Why should they matter to me?
To transfer money globally is very expensive. In 2021, global remittances (money transfers) were estimated at US$800 billion. With average remittance fees of 6.7%, banks and financial payment service providers earnt over US$54 billion on these transactions.
Stablecoins allow people to transfer money for significantly lower fees.
Using the Gemini USD stablecoin for instance, funds can be deposited by one party and withdrawn by another across different countries, incurring 0% transaction and withdrawal fees if both parties’ transaction through a digital wallet held with Gemini. Any additional fees incurred will likely come from traditional banks continuing to charge customers to move funds into and out of digital bank accounts.
The cost savings incur principally because digital ledger technology, through using a process called ‘validation’1, replaces the trust component traditionally provided by banks that ensures that one party has sufficient money in their bank account to pay for products or services offered by another party.
3. What is the potential of stablecoins?
By lowering the cost of transactions to near zero, stablecoins can lower risk and open up an enormous number of new business opportunities.
Let’s use the example a package travelling from London to Sydney that needs to pass through 10 different hands to reach its destination. Once the package arrives in Sydney, the lead provider will eventually distribute payment to each provider according to the agreed terms within each contract.
This can take time, however, as the agreed payment terms may be as long as 60 days after the service is delivered. As a result, each provider must have sufficient working capital (funding for day-to-day operations) to cover operating expenses until payment is received.
But what happens if the parcel delivery outlined in the transaction above had its own digital wallet that uses a stablecoin? As each provider completed their portion of the delivery, this digital wallet, which acts much like a bank account, would self-execute payments immediately to each party in the transactions if all the conditions outlined in a smart contract (a digital version of a paper contract) were met.
The cost savings possible from this approach when compared with the current approach are substantial. One of the biggest shifts is the fall in working capital requirements because payments are made immediately following the delivery of a service rather than 30-60 days which can be standard across many industries.
Working capital, which is often funded by expensive bank loans, can lock up balance sheet assets or income streams as a collateral condition from banks providing this funding. Removing a substantial portion of this debt can result in a less risky business that has more balance sheet flexibility to enter new business opportunities.
Other examples include more easily buying hard assets like property or shares, or even everyday consumer items for near zero transaction costs. Compare this to a Visa debit card which charges 0.5-1% or a Visa credit card which charges 1.5-2.5% on each transaction.
4. So why did Terra/Luna collapse?
The Terra stablecoin was directly connected to another token called Luna. Created by Terraform Labs, the Terra stablecoin used a mathematical algorithm that either buys (called minting) or sells (called burning) Luna token in order to maintain its peg to Terra that is equivalent to a price US$1 (called a USD peg). Miners responsible for managing this peg make money by trading either Terra or Luna tokens whenever its value shifts away from its US$1 peg.
On May 2nd, multiple investors suddenly decided to liquidate over US$300 million of Terra. This liquidation caught miners off guard who struggled to maintain the peg between Terra and Luna tokens.
Concerns over inflation as well as fear of the need for much higher interest rates, had also triggered heavy selling across global equity and fixed income markets through most of April and early May. Cryptocurrencies were heavily sold, triggering a collapse in Luna and the eventual destruction of Terra’s US$16 billion of assets in just 2 weeks.
5. What is happening with Tether?
One of the fundamental tenants of fiat currencies is that they are worth exactly what’s printed on the label. After centuries of use and the development of security measures that protected currency from counterfeiting, society accepts that a $1 note can purchase $1 worth of goods.
Many investors perceive that currency-backed stablecoins, like Tether and Gemini (aka GUSD, one of the first U.S. dollar-backed stablecoins), carry these same principles by holding an equivalent amount of assets against the value of tokens in circulation.
However, the lack of regulatory oversight over digital asset markets means that this is not true.
USD Tether is the largest stablecoin in circulation today. It held US$82 billion of assets on May 1st, 2022. Tether is run by a private organization (Bittrex) and remains loosely regulated through secondary markets around the world. While they claim in-a-round-about-way that they are fully backed by US$1 of assets for each US$1 of issued Tether tokens, a closer look on their website reveals that their assets are held across a mixed basket of assets including cash, fixed income, private loans, precious metals, investment funds and other. This is shown in Figure 2 below.
Figure 2 – Breakdown of Tether’s assets
After finally admitting in 2019 that Tether does not hold 100% of its assets in USD cash, Tether has at times used up to 40% of its asset base to speculate in the various assets classes outlined above.
This begs the question: if investors think that the tokens are backed by USD money, why would they do this?
Quite simply because the lack of regulations oversight of stablecoins permits Tether’s managers to do so. With over US$82 billion of assets and no requirement to pay either interest or dividends to Tether token holders, generating 1% annual returns could deliver US$820 million of income to the manager.
Once the token holders accepted this risk, the managers then likely added riskier investments to generate 2% and then 3% returns. The opportunity was too big to be ignored, with no clear risk of regulatory oversight issues.
The aggressive shift higher in global interest rates however has likely caused losses on the investments made with the Tether collateral pool. As long as investors do not redeem their funds by cashing out of the Tether tokens, it’s possible that markets will recover, and investment losses can be recovered.
However, the recent selloff in global assets coupled with the Terra/Luna collapse, has led to redemptions of US$7 billion or 9% of Tether tokens over the past week.
This is where things get interesting.
The lack of regulatory oversight over Tether means the scale of potential losses is unknown. We therefore need to think in hypotheticals until we know more.
For example, if Tether had 35% of its collateral invested in other asset classes than cash, and lost 10% on this portfolio, its NAV (net asset value) would fall to ~US$0.97. In regulated markets, this would be reported to holders and the price of the asset would fall to reflect these losses.
In Tether today, however, token holders can liquidate their tokens and receive US$0.998. If our hypothetical example outlined above is correct, sellers are currently receiving an additional US$0.033 of assets ($0.998 minus $0.965) that belong to other Tether token holders. This further reduces the remaining net assets of Tether’s collateral below the actual NAV until its manager provides a fully audited update on the true asset backing of this stablecoin.
If this hypothetical example is in fact correct, it’s highly unlikely that Tether can regain investors’ expectations of returning to par (US$1 value) without either Tether’s investment portfolio recouping recent losses or Tether’s management topping up the pool with its own funds to cover the losses.
6. What are regulators doing?
Global regulators are sitting up and taking notice following the collapse of Terra USD. Janet Yellen, the former Federal Reserve Bank Chair, and current Secretary of the US Treasury, has called for federal regulatory oversight of stablecoins before the end of 2022. The UK government is also responding with a spokesperson stating that “The government has been clear that certain stablecoins are not suitable for payment purposes as they share characteristics with unbacked crypto assets.”2
Something is clearly brewing to fix this issue before it causes long-term damage to cryptocurrency markets.
Substantially improving the regulatory oversight of stablecoins is the only alternative that will give stablecoin users confidence that they will one day replace fiat currencies. These regulations require stablecoin operators, whether private or government backed (CBDC or central bank digital currencies), to keep 100% of deposits at the respective central bank responsible for overseeing the currency they represent. No speculation of the collateral should be permitted under any circumstances.
The technology that underpins stablecoin offers tremendous potential for business and individuals to lower transaction costs, as outlined in the examples discussed in this note. The main issue that must be solved is uncertainty over the value of underlying asset backing of stablecoins that can be easily solved by stronger regulatory oversight. It took paper money centuries to remove this uncertainty. Let us hope lessons are learnt much faster for digital money to reach its potential.
1 Validation is the process of determining if a transaction conforms to specific rules to deem it as valid. Validators check if transactions meet protocol requirements before adding the transactions to the distributed ledger as part of the validating process