Terra’s rapid fall has reinvigorated crypto-skeptics. On May 10, amid the Terra crash, Treasury Secretary Janet Yellen argued before the Senate Banking Committee that stablecoins create “operating risks, which can threaten financial stability, and risks associated with the integrity and payment system.” Obviously, not every coin that calls itself “stablecoin” is stable, but Ms Yellen is wrong to think that stablecoins pose a systemic risk to financial stability.
A real stablecoin is a dollar-like token that is backed by at least $1 in assets. The most popular stablecoins, Tether’s USDT and Circle’s USDC, account for $72.5 billion and $54 billion, respectively, in circulating supply. Opportunistic regulators and politicians, notably the Securities and Exchange Commission’s Gary Gensler and Senator Elizabeth Warren, call stablecoins “unruly banks” and argue that they are vulnerable to running.
But Tether and Circle are different from banks. Unlike bank deposits, USDT and USDC can only be redeemed for amounts over $100,000 and only for a select group of Tether’s and Circle’s financial partners. Alternatively, most holders of these tokens can sell them on various exchanges or exchange them for goods and services. More importantly, Tether and Circle can also delay or suspend refunds at any time – a history-tested solution to run. This keeps their balance sheets intact and makes it impossible to “sell” either by attacking their currency peg to the dollar.
The only real risk to Tether and Circle is losses in their bond holdings. On May 12, Paolo Arduino, Tether’s chief technology officer, clarified that “in the past six months”, the company “has reduced the volume of commercial paper by 50%.” [sic]. All the reduced commercial paper was transferred to US Treasurys.” This means the Treasurys now have 60% of Tether’s reserves, and commercial paper 15%. Circle claims 76% of its reserves were in Treasurys and 24% in cash as of May 20. As for Tether or Circle to incur significant losses, that would require a large-scale default from companies or the government.In such a financial catastrophe, the stablecoin peg would be the least of our worries.
In contrast, “coupon coins” like Terra rely on decentralized finance protocols that mint new coins when their price is above theirs and sell interest bearing “coupons” when the price is below the exchange rate. The logic is that investors will buy coins to get the coupons, raising the price back to the peg level. But once the speculative demand for coins drops, the issuance of more high interest coupons accelerates the eventual collapse of the peg.
Terra was launched in 2019 and got a boost when its creator, Do Kwon, launched the Anchor Protocol, a platform that rewards users with 18% to 20% annual interest on Terra USD (UST) deposits, the Terra stablecoin. These bonuses were paid out of a reserve fund with the capital of the parent company Terra.
Ultimately, only UST and Luna (a redeemable sister code for UST) existed to provide access to Anchor Rewards for benefits. The more floor-to-ceilings issued and deposited on Anchor, the faster the Anchor reserve fund depleted and the more expensive it would be for Terra hedge fund investors to advocate for the peg of floor-to-ceilings on various exchanges. Bearers began cashing in their bonuses in late January, threatening to hook up the floor tanks. In early May, Terra’s parent company, along with outside investors, spent billions to stabilize the interconnection of underground tanks, but was unable to successfully restore market confidence. Just a few days later, the peg broke as investors sold off Luna and pulled their floor cabinets from Anchor. Instead of a dollar, today’s floor cabinets are worth just over a penny.
Cryptologists will refer to Terra as another episode of “tulip mania”. They will be healthier than they know. Amsterdam in the 17th century was awash in new fortunes, causing a bubble in the prices of tulips and futures. However, contrary to popular myth, tulip mania was not an unusual folk delusion, but rather a game of a small group of wealthy merchants, the end of which had little economic consequences for Amsterdam. Likewise, despite the struggles of retail investors, Terra has been a game of musical chairs for a relatively small group of large investors. The top 10 wallets using Anchor accounted for 27% of terrestrial vaults, and the top 1000 wallets occupied 82%.
Michael Hsu, Acting Currency Controller, recently said of Terra’s collapse that “there has been no contagion from cryptocurrency to traditional banking and finance.” The real lesson from Terra – as from the tulip mania – is that roulette games for wealthy speculators pose no systemic risk. Ms. Yellen should stop worrying about running on stablecoins. Real stablecoins are not wild banks. The US Treasury and the Federal Reserve have better things to do – such as controlling inflation that currently threatens the stability of the dollar itself.
Mr. Ferguson is a Senior Fellow at Stanford University’s Hoover Institution, and founder of Greenmantle. Mr. Rincon Cruz is a researcher at the Hoover Institution, and founder of Buttonwood, the DeFi/web3 open source software project.
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