As the crypto market reacts to the massive crash of the stablecoin UST and it’s sister coin Luna, the world is witnessing a significant loss of crypto market value. In November 2021 Bitcoin hit an all-time high of more than $68,000 per Bitcoin resulting in a crypto market value of $3 trillion. As of Tuesday that market value was at $1.51 trillion. The big question is, what threat do traditional fiat regulators see to the fiat economies as the role of crypto becomes greater and greater in the world’s financial markets? Do these regulators see crypto as a threat or a future threat? How will these regulators react and what impact will regulation have on the Crypto?
Impact of UST Stablecoin Crash
The cryptocurrency market shuddered Wednesday after the stablecoin UST plummeted to an all-time low of 30 cents.
UST, or TerraUSD, was off about 9% to $0.427965, while its sister token Luna was falling nearly 40% to $1.59 at last check, according to CoinGecko, down a staggering 99% from its April 5 all-time high of $119.98.
TerraUSD briefly lost its dollar peg over the weekend, pulling down Luna as well.
Bitcoin, the world’s largest digital currency, was off 7.5% to $29,759.54 recently, down 57.4% from its all-time high of $69,044.77 reached on Nov.10, 2021.
What Are Stablecoins?
Stablecoins are a class of cryptocurrencies that attempt to offer price stability and are backed by a reserve asset.
UST and Luna are the main tokens of the Terra protocol, a decentralized and open-source public blockchain protocol for so-called algorithmic stablecoins, which are backed by a computer code instead of collateral.
What Happened to UST?
UST plays the same role as stablecoins like Tether, which track the price of the dollar. But unlike Tether and other stablecoins, there are no traditional assets like cash or Treasuries in reserve to back it up.
UST is created (minted) by destroying its sister token, Luna, via smart contracts, a piece of computer code that determines the terms of a transaction (loans, trading, etc.) and don’t rely on any third party. And Vice versa: Luna is minted by burning UST and other stablecoins supported by the Terra ecosystem.
Luna is the native governance system of the Terra ecosystem.
UST’s dollar peg relies on the mechanism of creating and burning coins in tandem with Luna. Basically, investors can swap 1 UST for $1 of Luna. In doing so they destroy or burn UST. They basically take it out of circulation.
The Terra ecosystem protocols also have an arbitrage mechanism that allows investors to profit from price fluctuations. For example, strong demand for UST can push prices above $1. This means that investors can convert $1 worth of Luna to UST and pocket the difference.
When the price of USTs is too high, investors are encouraged to burn Luna and create USTs. Basically, they increase the supply of UST while decreasing the number of Luna in circulation. As a result, Luna becomes rare, which increases its value. Since the two tokens evolve in tandem, the value of the UST is also increased.
Normally, this mechanism would have the reverse happen when UST price is low. It is then necessary to burn UST and create Luna, which in theory contributes to stabilizing prices.
This balance is indeed difficult to hold in periods of high volatility. This is what happened the weekend of May 7 and 8. Hundreds of millions of USTs were sold almost simultaneously on Anchor, Terra’s trading platform, on the crypto exchange Binance and on decentralized exchange Curve Finance.
Some sources in the industry speak of a coordinated attack against UST because all the orders were sell orders. The platforms quickly lost much of their UST liquidity as many people tried to redeem their tokens at once.
What’s Happening Now?
Attempting to reassure the market, Do Kwon, the South Korean crypto entrepreneur who co-founded Terraform Labs, plans to buy $10 billion worth of Bitcoin through Luna Foundation Guard (LFG). These funds will serve as a backstop if the value of the UST collapses.
Bitcoin would thus become the reserve currency for the Terra ecosystem.
The plan is to allow UST holders to be able to redeem their tokens in Bitcoin. But how will this work? At the moment it is unclear how this will work because it was never expected that Bitcoin would play the role of Luna in the event of a crisis.
LFG currently holds $3.5 billion worth of Bitcoin (BTC). On Monday, the foundation reported disbursing $1.5 billion of those funds: it’s lending $750 million worth of Bitcoin to trading firms to protect the value of UST and it will use $750 million worth of UST to continue accumulating Bitcoins.
The Destruction Of Bitcoin?
Some fear, however, this reserve arrangement will push Bitcoin prices down. Indeed, if UST again loses its dollar peg, LFG would be forced to liquidate its Bitcoin positions, they fear.
“LFG is not trying to exit its Bitcoin position,” the foundation said. “The goal is to have this capital in the hands of a professional market maker.”
Treasury Secretary Yellen Cites UST Stablecoin Risk
Treasury Secretary Janet Yellen expressed concern about the troubles with UST, a stablecoin that has lost its dollar peg in recent days.
She said UST had “experienced a run” at a Senate Banking Committee hearing Tuesday.
Stablecoins have come under increasing scrutiny by regulators because of their growth and potential to cause a systemic risk to the financial system.
The algorithmic stablecoin UST, which is on the Terra network, is designed to keep a one-to-one peg with the U.S. dollar. But the stablecoin lost its peg over the weekend, dropping as low as $0.60.
It’s not clear what caused the stablecoin to lose its peg. UST is listed as the 10th largest cryptocurrency by market cap.
Over the weekend, Luna Foundation Guard, a nonprofit which supports the network and includes Jump Crypto, responded to the depeg by saying it would loan Bitcoin and UST funds to defend UST’s peg to the dollar.
Instead of being backed by dollars, UST is designed to keep its peg through a complex system connected with another Terra network token, LUNA.
The SEC had previously issued a subpoena for Terraform Labs, the creator of Terra, and its CEO Do Kwon. Given this weekends crash, will this focus become more intense?
SEC Chair Gensler Says Crypto Exchanges Are ‘Trading Against Their Customers’
Securities and Exchange Commission chair Gary Gensler said Tuesday crypto exchanges are sidestepping rules and may be “trading against their clients” in an interview with Bloomberg. According to Gensler, many of the largest cryptocurrency exchanges don’t separate their custody, market-making, and trading services like traditional exchanges do. The “commingling” of services could be problematic for clients’ interests, he says. Gensler also criticized stablecoins by pointing out that the three largest are all controlled by or have connections to major crypto exchanges. “I don’t think that’s a coincidence,” Gensler said during the interview.
Bitcoin is the largest cryptocurrency by market cap, and a good indicator of the crypto market in general, since other coins like Ethereum (and smaller altcoins) tend to follow its trends. Even though Bitcoin recently set another new all-time high, it was a normal uptick for the crypto, which is notorious for its volatility. That’s not to say investors should take swings in either direction lightly, and this is also why investing experts recommend not making any major investment changes based on these normal fluctuations.
Cryptocurrency is still very new, and everything from innovation to regulation can have an outsize impact for investors.
What Might Cause Regulators To Intervene?
Although TerraUSD maintains its tie to the dollar through an algorithm, investor runs on stablecoins that maintain reserves in assets like cash or commercial paper could spill over into the traditional financial system, causing stress in those underlying asset classes, say regulators.
With more companies’ fortunes tied to the performance of crypto assets and traditional financial institutions dabbling more in the asset class, other risks are emerging, say regulators. In March, for example, the Acting Comptroller of the Currency warned that banks could be tripped up by crypto derivatives and unhedged crypto exposures, given they are working with little historical price data.
Still, regulators overall are divided on the size of the threat a crypto crash poses to the financial system and broader economy.