TerraUSD: Stable Doesn’t Always Mean Safe and Sound
Over the weekend of May 7–8, 2022, Terraform Lab’s TerraUSD stablecoin (aka “UST”)—which was one of the top-three largest stablecoins by market share—plummeted to mere pennies from its previous $1 peg. The damage was done by the following Monday. Investors had lost over $18 billion invested (aka “locked”) into TerraUSD. Make that over $40 billion when combined with the value of Luna, Terra’s native token.
While the future of TerraUSD and other cryptocurrencies hang in the balance, there is one thing readers can take to the bank: stablecoin regulation is coming. And at least some stablecoin issuers appear to welcome it.
How Stablecoins Work
TerraUSD’s crash wasn’t supposed to happen. Stablecoins are designed to be just that—stable. As an asset class, they are intended to shield holders from price volatility by pegging to a certain fiat currency like the U.S. Dollar. Most stablecoins do this by maintaining reserves in the form of “safe” assets such as cash, Treasury securities, or commercial paper. Issuers of stablecoins like Tether, USDC, and Binance USD maintain one-to-one reserves comprised of high-quality assets, allowing full redemption at $1 to every holder in the event of a run.
As a prime example of the stability this can offer, following TerraUSD’s crash, Chief Technology Officer of Tether (issuer of the world’s most widely held stablecoin) reportedly tweeted that around 300 million Tether tokens were withdrawn in 24 hours “without a sweat drop.” Algorithmic stablecoins like TerraUSD, by contrast, are significantly under-collateralized and instead rely on demand-side arbitrage to stabilize the price.
Here’s how TerraUSD’s algorithm works: in the Terra ecosystem, users can swap $1 of TerraUSD for $1 of newly minted Luna (Terra’s native token), regardless of the market price of either token. If the price of TerraUSD falls below $1, traders can “burn” their TerraUSD (i.e., permanently remove the token from circulation) in exchange for newly minted Luna. This allows users to capture the risk-free profit in an arbitrage-like transaction. As the number of TerraUSD in circulation decreases, the corresponding value should increase (theoretically) until it reaches equilibrium. The converse is also true where traders can burn Luna to mint more TerraUSD if the value of TerraUSD climbs above peg. TerraUSD lost its peg a year prior in May 2021 when the value fell around 10% before quickly correcting as designed.
A common criticism of algorithmic stablecoins like TerraUSD is that they present greater risks compared to reserve-based stablecoins, in part due to reliance on human behavior and underlying user confidence that the algorithm will return the stablecoin to its peg. In this case, TerraUSD’s de-pegging began with several large withdrawals from Anchor Protocol (a decentralized savings, lending, and borrowing platform created by Terraform Labs that runs on the Terra blockchain). But rather than burning TerraUSD in exchange for newly minted Luna to arbitrage it back to peg, a panic ensued that resulted in a sustained, large-scale selloff that triggered a so-called “death spiral” for the algorithm. In other words, no one wanted Luna because everyone lost confidence in the algorithm.
Congress Is Considering the Rules of the Game
Following TerraUSD’s precipitous crash, Treasury Secretary Janet Yellen reiterated her call for swift stablecoin regulation during her testimony during a Senate Banking Committee hearing. Secretary Yellen had already expressed her concern previously that stablecoins were subject to “inconsistent and fragmented oversight” and offered little actual assurance that the obligated entity had the ability to meet its redemption liabilities. “In times of stress,” Yellen warned, “this uncertainty could lead to a run.” As fate would have it, that is exactly what happened to TerraUSD. Secretary Yellen said it was “highly appropriate” to pass legislation addressing stablecoins and that “we really need a consistent federal framework.”
Even though legislative proposals have varied in approach, we have some idea of what this framework might look like. Multiple proposals have hit the congressional floor, and there are likely many more to come. The Lummis-Gillibrand Responsible Innovation Act, for example, takes a sweeping approach, and among many other things attempts to distinguish digital assets that are commodities (probably most stablecoins), which would be overseen by the CFTC, from digital assets that are securities to be overseen by the SEC. Other bills have taken aim at bolstering reserves and restricting stablecoin issuance.
Yet another proposal is reportedly in the works from the bipartisan duo of Representative Waters and Representative McHenry, who have neared a deal that would deliver tougher rules for the crypto industry generally. Consideration of this proposal has been met with some resistance from certain factions, resulting in more delay. Treasury Secretary Yellen is said to have raised concerns with Waters over how the proposal would address digital assets held in custody on behalf of consumers, specifically that Treasury wanted changes that would require digital wallet providers to segregate assets in order to ensure preservation in the event of the provider’s bankruptcy.
The Big Question: Should Stablecoin Issuers Be Limited to Banks?
One of the biggest sticking points for stablecoin legislation is whether issuers should be limited to traditional banking institutions—or at least subject to bank-like oversight and regulation. Several proposals look to the Office of the Comptroller of the Currency (OCC) as the regulating authority to issue a special license or bank charter to certain entities for the exclusive purpose of issuing stablecoins and performing incidental activities.
The possibility that the OCC would provide a license or charter to non-banks to issue stablecoins appears inconsistent on its face with the views set out in a November 2021 report on stablecoins published by the President’s Working Group on Financial Markets, the Federal Deposit Insurance Corporation (FDIC), and the OCC. To guard against “stablecoin runs” in particular, that report recommended that any legislation “should require stablecoin issuers to be insured depository institutions.”
The legislative proposal being considered by Representatives Waters and McHenry supposedly would treat issuers more like banks.
The Executive Branch Has Already Begun Analyzing Stablecoin Policy
While Congress puts chisel to slab, the executive branch and various federal agencies have already begun evaluating how best to regulate digital assets and crypto-related activities. On March 9, 2022, President Biden issued an Executive Order on Digital Assets (the “EO”) outlining a first-ever, “whole-of-government strategy” for “addressing the risks and harnessing the potential benefits of digital assets and their underlying technology.” Among many other reports and studies, the EO requested a report within 180 days (or by September 5, 2022) from the Secretary of the Treasury, in consultation with the FDIC and others, on the “implications of developments and adoption of digital assets.” The report is to include specific policy recommendations including for “potential regulatory and legislative actions.”
From the OCC’s perspective, Acting Comptroller Michael J. Hsu agreed that “[g]etting stablecoins right from a regulatory policy perspective is important.” In remarks delivered in spring 2022, Hsu compared the $23 trillion U.S. economy—which is supported by $2.4 trillion of capital circulating in the banking system—to the roughly $2 trillion worth of crypto assets resting atop $180 billion of stablecoins. Hsu said the relationship can be depicted by an upside-down pyramid where instability at the bottom can cause the entire structure to destabilize.
Hsu also echoed the conclusion in the President’s Working Group report that a run risk is the leading risk to stablecoins. He discussed two approaches to mitigate run risk under our current regulatory framework. The first is based on money market regulation, which requires disclosure and sets asset holding requirements; the second is based on bank regulation and supervision.
If stablecoins were investments, then a money market approach could serve as “a starting point,” Hsu remarked. But given the “notable limits” of money market regulation to prevent runs, as seen during the 2008 financial crises, “[a] banking approach would be more effective.” To address the criticism that a banking approach would be inefficient and unduly burdensome to many would-be issuers, Hsu said that:
[i]f a stablecoin entity were tightly limited to just issuing stablecoins and holding reserves to meet redemptions, I would agree that the full application of all bank regulatory and supervisory requirements would be overly burdensome. Provided that the activities and risk profile of a stablecoin issuing bank could be narrowly prescribed, a tailored set of bank regulatory and supervisory requirements could balance stability with efficiency.
Hsu’s “tailored” approach above is probably consistent with a licensing regime or limited charter structure with attending restrictions on a non-bank stablecoin issuer’s activities. Yet Hsu has warned that a lower bar would make it “more likely [that] a risky issuer blows itself up sparking contagion across peers.”
In a significant first step for the FDIC following the EO, the agency issued a letter to all its supervised institutions requesting notice of their intent prior to engaging in, or if currently engaged in, a “crypto-related activity.” The FDIC defined “crypto-related activity” broadly and non-exhaustively to include the following: acting as a crypto-asset custodian, maintaining stablecoin reserves, issuing crypto and other digital assets, acting as market makers or exchange or redemption agents, and participating in distributed-ledger based settlement and payment systems. The agency said these activities are “known existing or proposed crypto-related activities engaged in by FDIC-supervised institutions.” The FDIC hypothesized that a disruption in a crypto-related asset could result in a “run” on that asset that could “create a self-reinforcing cycle of redemptions and fire sales of financial assets, which, in turn, could disrupt critical funding markets . . . [and] have a destabilizing effect on the insured depository institutions engaging in such activities.”
The SEC staff have also weighed in on accounting standards for digital assets. Most legislative proposals so far exclude stablecoins from the ambit of securities laws. Even still, the SEC staff expressed their views in Staff Accounting Bulletin No. 121 concerning entities that safeguard crypto assets for users. Those entities most report a liability on their balance sheet for the fair value of those assets, so says the SEC. Before this guidance, an entity generally would not report safeguarded digital assets on its balance sheet unless it controlled those assets. Several GOP lawmakers responded to this staff bulletin by sending a letter to the SEC arguing it amounts to improper rulemaking and makes crypto custody by banks “economically infeasible.”
Government and Industry Mull Over a U.S. Central Bank-Backed Stablecoin
The United States has also begun exploring the potential role for a United States Central Bank Digital Currency (CBDC). Secretary Yellen has said that a CBDC could contribute to a more efficient payment system and may have the potential to mitigate some of the risks posed by “private” stablecoins. Biden’s EO placed the “highest urgency on research and development efforts into the potential design and deployment options of a United States CBDC.” Yellen said that a CBDC would present a “major design and engineering challenge that would require years of development, not months.”
Beyond the massive technical feat, CBDCs face other hurdles including skepticism from some quarters of the banking industry. For example, in May 2022, the American Bankers Association (ABA) and Bank Policy Institute submitted separate letters arguing that the risks of a CBDC outweigh the potential benefits. These industry groups were responding to a January 2022 discussion paper on CBDCs from the Federal Reserve,.
The Fed’s paper discussed, among other things, the potential disintermediating effect a CBDC could have on traditional banks, which play a critical role in credit provision and other essential financial services. The Fed also raised the possibility, however, that this effect could be mitigated by designing a CBDC that is slightly less attractive than nondigital money by limiting interest-bearing capability or capping the amount an “end user” can hold. Assuming holdings were capped at $5,000/$10,000 per end user, the ABA’s response letter estimated that even a non-interest-bearing CBDC would cause deposit losses upwards of $720 billion/$1.08 trillion—a large enough scale to destabilize the financial system.
In June 2022, Fed Chair Powell spoke of a U.S. CBDC in a positive light, stating that it could “potentially help maintain the dollar’s international standing.” Fed Vice Chair Brainard has also made the case for a CBDC with certain limitations; Fed Governor Waller has made the case against. The Office of Financial Research released a working paper concluding that “a well-designed CBDC may decrease rather than increase financial fragility.”
Written with the assistance of Jones Day associates, Zach Sharb and Elijah Stone.
