Stablecoins, Bank Runs, and Death Spirals

“The Terra Protocol with its balance between fostering stability and adoption represents a meaningful complement to fiat currencies as a means of payment and store of value.”1

Transacting in cryptocurrency has been fraught with limitations since it came onto the scene over a decade ago.  Widespread adoption has been slow, as inherent volatility creates reluctance for businesses to accept crypto payments and hesitancy for customers to integrate crypto in their daily lives.  Paying a mortgage or buying an ice-cream cone, for instance, with a currency whose value can fluctuate wildly over the course of days, weeks, and months is generally unappealing for both the buyer and the seller.  As a result, cryptocurrency and its adjacent ecosystem have largely been sidelined to groups of enthusiasts and speculators. 

To help circumvent this problem, issuers developed stablecoins – a coin product with an objective to maintain a one-to-one peg with some real-world asset, typically an established currency such as the US Dollar.  Such stablecoins fall into two broad categories:

  • Traditional stablecoins attempt to maintain their pegs through holdings of collateral in real-world assets.  As long as the value of the real-world assets (government bonds, fiat currencies, etc.) cover the value of issued stablecoins, traders can redeem their stablecoin for $1 from the issuer at any time, who then sells $1 worth of real-world assets to cover the redemption, as needed.  Critics argue, however, that such coins defeat the purpose of the decentralized finance system at the heart of crypto by introducing a central point of failure and a reliance upon traditional assets.2
  • Algorithmic stablecoins, as their name implies, attempt to maintain their pegs through algorithmic procedures.  A decentralized network of arbitrageurs defends the value of the peg by adjusting the supply and demand balance of the stablecoin in a process known as “minting and burning.”  This mechanism typically works by first introducing a sister crypto token into the system.  The stablecoin can always be redeemed within the protocol for the equivalent of $1 in value of this sister token.3  If the stablecoin value falls below $1, arbitrageurs buy and redeem the stablecoin (i.e., “burn it”) in exchange for $1 worth of the sister token, which is “minted” when the stablecoin is redeemed.  Under these rules, the stablecoin supply is reduced (thereby increasing its value), and the sister token supply is increased (thereby reducing its value). The reverse mechanics occur when the stablecoin value exceeds $1.  As long as the sister-token has a positive price, the system holds (in theory).  Maintenance of the stablecoin peg exists entirely within the digital ecosystem, which proponents point to as a benefit while critics claim it is a vulnerability.

Each system is susceptible to failure, yet both lack the governance structures and regulatory regimes that ensure depositor confidence.  For instance, an external shock to a traditional stablecoin’s reserves could induce investor panic and capital flight out of the coin as the issuer sheds assets to meet redemption demands, similar to a classic bank run.  Algorithmic stablecoins, operating entirely within the digital world, may be immune to these external shocks, but instead could be exposed to attacks on their platforms (i.e., investors deploying large amounts of capital to “break the peg”) and/or so-called “death spirals” whereby the mint and burn defense breaks down, dramatically increasing the supply (and decreasing the value) of the sister token used to maintain the peg.

An external shock in late 2021 to the reserves of Tether (“USDT”), the world’s largest traditional stablecoin with over $65B in circulation, brought its asset holdings into question.  Tether had been criticized for investments in short-term Chinese debt and risky crypto-backed loans.4  When Evergrande, the large and highly indebted Chinese real estate developer, defaulted on two bonds in late 2021, Tether’s perceived exposure became paramount to investors, although the currency survived without a bank run.5 Nonetheless, since the controversy arose, Tether claims to have reduced its riskier commercial paper reserve holdings in favor of safer US Treasuries.6

The world’s largest algorithmic stablecoin, TerraUSD (“UST”), was less fortunate and suffered a “death spiral” alongside its sister token LUNA during a one-week period in May 2022.  An unexpected influx of UST selling (not to be confused with burning of UST) put downward pressure on its price, causing UST to de-peg.  Concurrently, depositors of UST in the so-called “Anchor protocol” pulled their UST en masse in order to trade out of the de-pegged currency and mitigate losses.7  The resulting price deterioration in UST triggered the arbitrage mechanisms to defend the peg by buying/burning UST and minting LUNA.  With each transaction to prop up the value of UST, however, the supply of LUNA increased and created an uncontrolled inflationary cycle in LUNA that ultimately drove its price toward $0.  Holders of LUNA and UST were wiped out, as no demand for LUNA meant no remaining value for UST. 

Over $40 billion in UST and LUNA value was lost in the week of the Terra collapse.  A consortium of defenders mostly supported by Terra’s founder also lost nearly $3 billion worth of bitcoin while attempting to stabilize the system by selling bitcoin to purchase collapsing LUNA and reverse the spiral.8  The collapse rippled through the cryptocurrency world, taking down multi-billion-dollar crypto hedge fund Three Arrows Capital in its wake and causing a $16 billion bank run on the Tether stablecoin.9

What recourse exists for investors in the Terra ecosystem and similar projects remains to be seen.  A recent class-action lawsuit filed in California, for example, claims Terraform Labs (the creator of UST and LUNA) and related entities induced retail investors to purchase Terra ecosystem coins and tokens at inflated prices.10  Other allegations involving Terra involve claims of deceptive marketing, spoofed volumes, concealed bailouts of UST, and embezzlement.11  For these reasons, some observers bemoan the rapid fall of UST as the final straw for algorithmic stablecoins.

1Evan Kereiakes, et al., “Terra Money: Stability and Adoption,” Apr. 2019, p. 1, https://assets.website-files.com/611153e7af981472d8da199c/618b02d13e938ae1f8ad1e45_Terra_White_paper.pdf.

2Stablecoins collateralized by crypto holdings are a popular subset of the traditional stablecoin.

3The price of the sister token is allowed to fluctuate based on market dynamics, leading to a variable relationship between the number of sister tokens that are minted when one stablecoin is burned.

4Zeke Faux, “Tether’s $69 Billion Mystery: Five Takeaways From Bloomberg Businessweek’s Cover Story,” Bloomberg.com,            Oct. 7, 2021, https://www.bloomberg.com/news/articles/2021-10-07/can-you-trust-stablecoin-tether-5-takeaways-from-bw-s-cover-story.

5David Z. Morris, “Evergrande and China’s Looming Risk to Tether,” CoinDesk.com, Oct. 19, 2021, https://www.coindesk.com/markets/2021/09/17/evergrande-and-chinas-looming-risk-to-tether/.

6Tim Copeland, “Tether says that it holds no Chinese commercial paper,” The Block.com, Jul. 27, 2022, https://www.theblock.co/post/159815/tether-says-that-it-holds-no-chinese-commercial-paper?‌utm_source‌=basicrss&utm_medium=rss.

7Anchor, operated by the same entity that created UST and LUNA, serves in essence as a digital bank that lends depositors’ holdings of UST to borrowers.  This is a process known as “staking” in cryptocurrency parlance.  In return, depositors (or “stakers”) of UST in the Anchor protocol received yields of 19.5%.  Upon pulling their deposits from the Anchor protocol in May 2022, UST owners traded their coins on the open market for other crypto products not suffering from increased volatility and price collapse (i.e., holders of UST preferred trading out of UST in exchange for other products like Ethereum or Bitcoin, for example, to burning the UST in exchange for a rapidly deteriorating LUNA).  See Krisztian Sandor, “Investors Flee Terra’s Anchor as UST Stablecoin Repeatedly Loses $1 Peg,” CoinDesk.com, May 9, 2022, https://www.coindesk.com/markets/2022/05/09/investors-flee-terras-anchor-as-ust-stablecoin-repeatedly-loses-1-peg/.

8Sidhartha Shukla and Emily Nicolle, “Cost of Failed Terra Stablecoin Rescue Reaches $2.9 Billion,” Bloomberg.com, May 16, 2022, https://www.bloomberg.com/news/articles/2022-05-16/cost-of-failed-ust-peg-defense-2-9-billion-in-reserves-spent.

9Tether’s reserves were sufficient to meet the demand for redemptions.  See David Canellis, “The Historic Significance of Tether’s $16B ‘Bank Run,’” Blockworks.com, Jul. 1, 2022 https://blockworks.co/the-historic-significance-of-tether-16b-bank-run/.

10"TERRA ALERT: Bragar Eagel & Squire, P.C. Announces that a Class Action Lawsuit Has Been Filed Against TerraForm Labs Ptd. Ltd. and other Defendants and Encourages Investors to Contact the Firm,” Businesswire.com, Jul. 24, 2022, https://www.businesswire.com/news/home/20220724005041/en.

11Liam ‘Akiba’ Wright, “FatMan Terra announces class action lawsuit against Terraform Labs, Do Kwon, Jump Capital,” Cryptoslate.com, Jul. 26, 2022, “Terra – UST/Luna,” Scott-Scott.com, https://cryptoslate.com/‌fatmanterra-announces-class-action-lawsuit-against-terraform-labs-do-kwon-jump-capital/; https://scott-scott.com/cryptocurrency-cases/terra-ust-luna/.

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