$45B Stablecoin Rout Confirms Worst Fears about Crypto’s Need for Reserves

The spectacular collapse of a top-three stablecoin last week has erased $45 billion and left crypto with a confidence crisis that goes far deeper.

But the implosion of the TerraUSD stablecoin and the sister coin that was supposed to maintain its dollar peg has left many critics of the supposedly safe branch of crypto, which many regulators and central bankers fear is a threat to global financial stability, saying “I told you so.”

But it may also have left one cryptocurrency a winner: USD Coin, or USDC, the most transparent of the major stablecoins.

While the crypto market took a sharp dive in the wake of what amounted to the crypto version of a bank run, USDC’s market capitalization is up about $3.5 billion since May 9, when the problems began. Its main competitor, market leader tether, or USDT, is down about $9 billion in that time.

And, USD Coin has been trading a bit above peg in the past two weeks.

Tether, which depegged by several cents very briefly around 3:30 a.m. on May 12, has remained just a little bit — fractions of a cent — under peg.

See this: Tether Breaks Buck as Stablecoin Panic Spreads

But as the stablecoin market takes a growing place in crypto use in merchant payments and other uses beyond facilitating the trading of crypto on exchanges, the fear is that a run could spread beyond crypto.

Unstable Confidence?

Most stablecoins are backed, in theory, by a one-to-one cache of dollars and highly liquid short-term Treasury notes that allow them to maintain a price of $1 regardless of market conditions. But that price isn’t directly supported by that basket of currency and near-money. In reality, its market value is supported by traders’ confidence that they can exchange one stablecoin for $1 in fiat currency on demand.

Read also: Stablecoins Are Better, Safer, More Innovative Payments Solution Than Bitcoin

Stablecoins Are Unregulated Private Currencies Threaten Investors, Banks and Global Financial Stability

TerraUSD was something different, even though it went by the same name. An “algorithmic stablecoin,” its dollar peg was supported by the ability to trade one UST coin for one LUNA token, with the $1 price of UST maintained by an automated arbitrage mechanism.

See here: PYMNTS DeFi Series: What Is an Algorithmic Stablecoin? DAI and the Fiat-Free Dollar Peg

“Creating a decentralized form of money on which you can build an entirely new type of permissionless financial ecosystem is the holy grail of cryptocurrency, and that’s exactly what Terra does,” TerraUSD founder Do Kwon said in a recent promotional video, Bloomberg noted.

It also set up a decentralized finance (DeFi) platform called Anchor that offered up to 20% yield for staking UST — which sounds on the face of it too good to be true — that nonetheless spurred a fear-of-missing-out, or FOMO, run for UST.

Then everything went sideways after several huge LUNA owners sold large amounts of tokens at once.

Run, Run, Run Away

UST lost its dollar peg by a few cents over the weekend of May 7. A crisis of confidence began to build, spiraling into a full-on meltdown as more LUNA owners scrambled to sell. LUNA’s market cap, $34.5 billion on April 9, is now under $1 million and it’s impossible to sell. LUNA’s price, more than $64 on May 9, fell to $.004 cents by May 13.

It was, in effect, a bank run, sped by the ease of selling crypto, that lack of any backing institution like the Federal Reserve or Federal Deposit Insurance Corp. This is exactly what the President’s Working Group on Financial Markets (PWG) warned about in its Nov. 1 Stablecoin Report.

Read this: Yellen: Terra’s Fall Shows Stablecoin Dangers

“Failure of stablecoins to maintain a stable value could expose stablecoin users to unexpected losses and lead to stablecoin runs that damage financial stability,” it said, citing their rapid growth. In TerraUSD’s case, that was $180 billion before it collapsed.

It recommended that the reserves be held only in cash and stablecoins only issued by federally insured banks.

Apples and Oranges

Algorithmic stablecoins are not like dollar-backed stablecoins, supporters argue. After all, it was the two-coin exchange rate mechanism that failed, causing the run.

What’s the difference? The USDC reserves are regularly and publicly audited by Grant Thornton, a major, global accounting firm. In April, Circle announced that the USDC reserve funds would be held in custody by BNY Mellon and that the company plans to apply for a federal banking charter.

Read more: In Winning DeFi, Circle’s USDC Shows It Can Be the No. 1 Stablecoin

Issued by Circle and the top cryptocurrency exchange Coinbase, USDC is backed by a one-to-one basket of dollars and highly liquid short-term treasury notes. While there was an uproar when it first released an audit showing non-liquid investments, Circle quickly reversed course, selling them off within a few months.

Tether, the company that issues USDT, has had a number of clashes with regulators over its reserves, including an $18.5 million settlement with the New York Attorney General and $41 million with the Commodity Futures Trading Commission (CFTC) over the size of its claimed reserve. And in February, Nellie Liang, the Treasury Department’s undersecretary for domestic finance, told the House Financial Services Committee that her “understanding” based on Tether’s disclosures is that USDT “may not be … fully collateralized under all conditions.”

See more: With Short Sellers Gunning For Tether, Stablecoins Risk Grows

Tether’s most recent “assurance” report, released on May 19 by the Cayman Islands-based firm MHA Cayman, found that a little more than 25% of its $82 billion reserve is still in commercial paper, down from 44% at the beginning of the year. About 43% is in cash and treasury bills.

But critics’ point is that to keep the confidence that is necessary to prevent a dollar-peg destroying run on any stablecoin, investors must feel confident that they can trade them in for fiat on-demand — not in months.

Beyond that, they worry that if stablecoins continue to grow as rapidly as they have — the total market cap was $180 billion before TerraUST imploded — a fire sale of non-cash assets could spill into the broader markets.