This is a guest article by Robert McCauley, Nonresident Senior Fellow at Boston University’s Global Development Policy Center and Associate Member of the Faculty of History at Oxford University.
The fate of stablecoins is fateful for the entire crypto complex. This does not stem from their size but from the essential liquidity role they play.
To refine the technical and legal difficulties of transactions between crypto and real dollars, the crypto market has devised its own quasi-dollars. These serve as vehicle currencies in crypto trading, providing liquidity and crucial collateral services. The major cryptocurrencies, bitcoin and ether, are bound to be worth much less in a trading environment with altered stablecoins. As the largest stablecoin fights for its life, it’s not too early to step back and consider what’s at stake.
From euphoria to distress. . .
At its peak valuation of $3 billion in early November, the crypto mania enjoyed euphoria to the moon. Operating to a large extent in a legal no man’s land, mania has prompted more than most market players to invent its own currency and build its own credit and leverage structures.
The crypto universe went from euphoria to distress in the months following the price spike. The distress is also known as the Wile E. Coyote moment, when the cartoon character ran down the side of the cliff and the Warner Brothers physique doesn’t fall until he looks down. Distress is characterized by those with more insight moving to get their hands on real money.
The movement toward cash by non-HODL (“hold on for life”) crypto holders has acted to drive down crypto prices. Yet, stablecoins not only maintained their price, but continued to grow in overall size. In October 2021, they weighed 127 billion dollars, more than half of which by the market leader.
Although there are several stablecoins, the four main ones – tether (USDT), USDC, BUSD and terra (UST) – account for 90% of the market. Their percentages are 46, 24, 10 and 10 respectively.
The asset class reached an aggregate measured value of $180 billion at the end of February. It held around this level until May, until distress hit stablecoins late last week. In retrospect, what’s odd is how the stablecoins kept rolling, Wile E. Coyote-style.
What was the order of play? In 1992, testing of the exchange rate mechanism spread from the small and peripheral to the center. The Finnish mark was eliminated first, then the lira and the pound were attacked, and finally the French franc. Similarly, the first stablecoin in sight was on the periphery.
Terra had three knocks against it: size, algorithmic construction and high interest rates. In terms of size, the growth of the UST saw it overtake the BUSD last month.
Many readers are now familiar with the difference between an algorithmic stablecoin and a backed stablecoin, although the difference is still worth defining. The latter is (or pretends to be) an unregulated money market fund. Its pseudo dollars are backed by something like cash: bank deposits, treasury bills and commercial paper. Long periods of stable outstandings raise questions about how the price of tether has been stabilized: is it through (legally reportable) redemptions by tether, market operations by its operators, or stabilization of speculation by d ‘others ?
Terra, an algorithmic stablecoin, claimed to be superior by not having such a foothold in traditional finance. After all, a government can seize these assets or prevent dealers from buying and selling them. Stable terra derives its stability from the pre-programmed trade against a floating token, luna. If Terra falls below par, a trader can buy it at a discount and use it at par to buy a dollar’s worth of luna, regardless of the luna’s price. After selling the luna, the trader pockets the discount.
But support for terra’s face value depended on trades that expanded luna’s supply, so faltering demand meant prices fell and turned safe arbitrage into a loss.
Interest on UST was the third strike. The terra-luna setup included the Anchor protocol (why not Acme, Wile E Coyote’s smart device mail-order source?) paying 19% APY. And whenever you hear someone talking about 19% returns on an asset promising stable value against the dollar, get your hands on your wallet.
In addition to being obviously unsustainable, this rate attracted the most conspicuous USTs to a single visible location. Anchor had deposits of a record 14 billion UST on Friday (out of $18 billion in circulation), but only 9 billion UST on Monday and 2.6 billion at pixel time. Transparency of total deposits could only be useful if coordination among depositors was required. Big sell-offs on the exchanges sent UST’s price below par and signaled that the bots would pump luna.
An analogy is a fine piece of financial engineering from the 1980s: by reset junk bonds, which was part of the takeover of RJR Nabisco by KKR in 1989. The coupon of these bonds had to be reset periodically to bring the securities back to par. Once RJR Nabisco’s finances got into trouble, an interest rate that brought the bonds down to par would bankrupt the company. Only KKR bringing new equity to the deal kept the company’s finances from blowing up.
The shrewd and not-so-decentralized organizers of UST had already started preparing their creation for its test by buying bitcoins to back it up. So far, the suggestion that they have pledged some of their $3.5 billion in bitcoin holdings to the defense of the UST has done more to upset bitcoin holders than to support the UST.
. . . panic and collapse?
It was fair to point out, as some did earlier this week, that backed stablecoins are different. Undoubtedly, they are not as unstable as algorithmic stablecoins. Nevertheless, the path from UST to USDT was as short as D, as in Distress. Distress arises when some sharpen their perception of the difference between newly invented quasi-money and reality and deed. Margin calls can advance this process.
It’s not that USDT is unregulated. In 2008, the Primary Reserve Fund proved that SEC regulation was not proof against a ball-busting money market fund. And March 2020 showed that races can hit money market funds even without breaking the bank. If stablecoins were to become banks with capital, perhaps Paul Volcker should have recommended the same for money market funds in the late 1970s.
On the contrary, Tether is a “company that seemed to be practically padded with red flags”. the business week The cover story from last October is worth re-reading: a glossy leader shouted fire, but patrons in the packed theater remained seated. Outrage greeted tether’s first pie chart of its holdings released the previous May.
Speculation as to debtors and the nature of Tether’s reported commercial paper holdings varies. Is it paper issued by struggling Chinese property developers? IOUs backed by crypto-currencies? (How could these margin calls play out?) Or worse? The mix might make the commercial paper of Lehman Brothers, which failed at the Primary Reserve Fund in September 2008, look pretty solid. If we attend the torschlusspanikthe oddity is how long it took.
The stablecoin crypto vehicle
It may seem like stablecoins are a sideshow. Their market capitalization at the end of October 2021 represented less than 3% of the crypto market. The share has since increased, but is still not significant.
Nevertheless, trading and therefore the liquidity of the crypto market depends on stablecoins. In particular, decentralized finance runs on stablecoins. Tether’s market cap of over $80 billion is now about a tenth of the joint market cap of bitcoin and ether, but its measured daily transaction volume is greater than their joint turnover.
Bitcoin price discovery takes place in derivatives transactions where tether serves as margin and settlement currency. What trading dollars against euros is to currencies, trading bitcoins against tether is to crypto. On the Binance exchange, the pricing of reassuringly named perpetual swaps involving bitcoin and tether drives bitcoin prices in US dollars and influences crypto prices more broadly.
Without tether, or at least without stablecoins, how the crypto complex works is unclear. Problems with vehicle money would undermine the liquidity of the entire crypto complex, just as the “dollar shortage” of late 2008 hurt the liquidity of the entire forex market. Less liquid assets are worth less. And if a top stablecoin essentially becomes a worthless entry on anyone’s spreadsheet, that would suggest that other cryptos might go to zero.