Why Policy Makers Should Pay Attention to Stablecoins

Over the last weekend, the peg binding algorithmic stablecoin TerraUSD (UST) to the U.S. dollar broke, resulting in huge losses. Now, regulators need to pay close attention to stablecoins and their operational design. 

UST Stablecoin Mechanics: How Did the Loss Happen?

TerraUSD (UST), an algorithmic stablecoin with a value pegged to USD, lost its peg twice over the last couple of days and was yet to regain it by the time of going to press.

This collapse is attracting a lot of attention because it comes with a number of risks for both institutional and retail investors. Although this coin has a very small market cap, it could have huge implications on the market, especially on the regulations of stablecoins

The price of UST dropped to 23 cents, with a 24-hour high of 92 cents. If this was for a standard crypto coin, it would be okay because of the current high volatility, but it is a stablecoin, meaning that its price should be 1:1 to the United States dollar. 

For most readers, the expectation is that the value of stablecoins should always follow the asset pegged to them. Therefore, they do not have to worry about the volatility in the crypto world. One way of achieving this is backing the stablecoins with reserves. This is the approach used with stablecoins such as USDC, USDT, and BUSD. For every unit of the stablecoin, there is a matching dollar on the reserve. 

Algorithmic stablecoins work differently. Instead of relying on fiat money in reserves, each comes with two tokens: the stable coin and a sister token. The sister token is created or burnt to control the price. In the case of TerraUSD, the sister token is LUNA, which can be invested in the Terra ecosystem. Theoretically, UST should always be redeemable for LUNA at the prevailing price of USD1 per UST.

Luna Foundation Guard (LFG), a Singapore registered non-profit organization designed to support UST’s price stability, said that one way of maintaining the LUNA peg is arbitraging trades. Other methods include incentives, open market operations and dynamic protocol levers.

The Outside Impacts of the UST’s Dollar Peg Loss 

When UST lost its peg, a lot of people incurred losses or are still losing. There are broader market implications, and this includes the regulations. Some of the unconfirmed reports indicate that LFG was seeking about USD 1.5 billion in funding to leverage the UST’s peg. Therefore, the regulators must be pretty alert to this. 

Already, Janet Yellen, the Treasury Secretary, brought up the issue during a U.S. Senate Banking Committee hearings. “I would note that there was a report this morning … TerraUSD had experienced a run and declined in value,” Yellen said on Tuesday. She added that she thought stablecoins were developing rapidly and posed a risk to financial stability. Therefore, she pointed out that a framework is needed. 

Congress is also likely to pay attention. According to Ron Hammond from the Blockchain Association, the main policies have been directed at asset-backed stablecoins. However, he posits that the focus has now changed with the loss of the UST’s dollar peg. 

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