UST's 'Reckless' Run Triggers Crackdown on Stablecoins

If the crypto industry was looking to prove the merits of stablecoins, May 9 did it no favors.

Janet Yellen, the U.S. secretary of the treasury, said it was “urgent” for Congress to pass new legislation to regulate stablecoins the day after the meltdown of UST, the algorithmic stablecoin supported by Terra.

Substantial Market Power

“[Stablecoins] run risks which could threaten financial stability,” Yellen testified in a Senate Banking Committee hearing. “Risks associated with the payment system and its integrity, and risks associated with increased concentration if stablecoins are issued by firms that already have substantial market power.”

Terra certainly had market clout going into this week. Its flagship token, LUNA, boasted a $40B market capitalization in April. And Do Kwon, Terra’s leader and self-styled “Master of Stablecoin,” had emerged as a DeFi superstar as LUNA skyrocketed.

Slipped its Peg

But Terra’s pledge to redeem 1 UST for $1 worth of LUNA was a thin reed to support such a weighty proposition. And when LUNA cratered amid the crypto selloff, well, all bets were off for UST and it slipped its peg by an astonishing 40% on Monday.

After rebounding Tuesday to $0.90, UST has tumbled to around $0.40 in mid-morning trading London time, according to CoinDesk data. Such a precipitous fall for a stablecoin, which is supposed to remain steady in volatile markets, is catastrophic.

UST’s fall. Source: Coingecko

The episode is bound to light a fire under lawmakers and regulators in Washington as the Biden Administration prepares a new oversight regime for the cryptocurrency industry. As it happens, Yellen, a former chair of the U.S. Federal Reserve and longtime skeptic of stablecoins, is playing a key role in that initiative and is preparing to release a comprehensive report on crypto.

Girding for the fallout, seasoned players have turned their ire on Terra and the Luna Foundation for their management of UST.

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The Defiant

“Luna was reckless and now they’re going to bring the wrath of the regulators on this industry,” Ryan Sean Adams, co-founder of the media company, tweeted. “They’ll demand stablecoins issuers be regulated like banks.”

If that’s the case, it would mean stablecoin providers must back their tokens with approved reserves and disclose their collateral levels to regulators, and the public. That may not be the worst thing in the world.

Pegged and Steady

Stablecoins are designed to let investors trade in the crypto market without going to the hassle and expense of converting to fiat currencies. Those backed by U.S. dollars instead of digital assets or arcane algorithmic formulas are weathering the storm just fine. Circle’s USDC and Tether’s USDT remain pegged and steady.

“Central banks calling for stablecoins to have adequate reserves may have a point after all,” tweeted Simon Taylor, the co-founder of 11:FS Foundry, a London-based fintech and blockchain consultancy.

As for what comes next, Sen. Pat Toomey (R-Penn.), the ranking member on the Banking Committee, has already drafted legislation to create a new regulatory framework for what he calls “payment stablecoins.” Toomey wants to require stablecoin issuers to be federally licensed.

Adams and other observers are worried a new regime may not differentiate between algorithmic stablecoins and their more staid, dollar-pegged counterparts. The next few months will prove pivotal for a stablecoin industry that has multiplied 18 times, to $175B in market value, in the last 24 months, according to CoinGecko data.

Yellen has long had her eye on stablecoins. As the chair of the Financial Stability Oversight Council she oversaw a report in 2021 that anticipated the very problems now poleaxing UST.

“If stablecoin issuers do not honor a request to redeem a stablecoin, or if users lose confidence in a stablecoin issuer’s ability to honor such a request, runs on the arrangement could occur that may result in harm to users and the broader financial system,” it states.

The market cap for stablecoins has exploded since 2020. Source: CoinGecko