How Terra’s Debacle Will Affect Future Stablecoin Regulation

The collapse of the Terra ecosystem and subsequent decoupling of the value of its algorithmic stablecoin TerraUSD (UST) to an all-time low of $0.30 has cast doubt on the future of not just algorithmic stablecoins, but all stablecoins.

UST’s success and stability are intertwined with its siblings, Luna, which creates an arbitrage opportunity that should theoretically keep the price of UST stable. If the price of UST falls below $1, it can be burned in exchange for LUNA, which reduces the supply of UST and increases its price.

Conversely, if the price of UST exceeds $1, LUNA can be burned in exchange for UST, which increases the supply of UST and reduces its price. This creates a mechanism and an incentive to keep the price of UST at $1 as long as conditions are normal and everything works.

Although algorithmic stablecoins are generally not backed by assets such as other stablecoins, the Luna Foundation Guard (LFG), the organization responsible for developing UST and the wider Terra ecosystem, has built a reserve of Bitcoin (bitcoin) is used when UST is de-pegged from the US dollar.

The idea is that if the price of UST falls significantly, BTC can be lent to traders who will use it to buy UST and push the price up, re-pegging it to the dollar. Thus, LFG deployed over $1.3 billion worth of BTC (42,000 coins priced at $31,000 each) to traders who intend to use it to buy UST, creating demand pressure and supporting its price. However, this did not save the collapsed ecosystem, and the spiral effect eventually collapsed the price of the LUNA token and its stablecoin.

After the crash, even centralized stablecoins such as Tether’s USDT, lost its peg to the dollar and fell to a low of $0.95. The collapse of Terra resulted in high volatility in the decentralized finance market as stablecoins act as a bridge to various decentralized finance ecosystems.

Given the collapse of the UST, Justin Rice, vice president of ecosystems at the Stellar Development Foundation, is skeptical about the future of algorithmic stablecoins. He told Cointelegraph:

“What we’re seeing now, not for the first time, is an optimistic balancing mechanism that unravels as a result of humans’ natural response to market conditions. Keeping algorithmic stablecoins pegged when things change sideways is a challenge, you You have to rely on external intervention to get things done.”

He also advocates for full transparency of stablecoin issuers through third-party audits. Denelle Dixon, CEO and executive director of the Stellar Development Foundation, hopes the recent debacle will drive conversations among lawmakers about stablecoin regulation. She told Cointelegraph:

“We’ve seen significant progress in the U.S. pushing stablecoin legislation. We’ve seen bills on both sides of the aisle that understand these issues and can move the industry forward by providing clarity and guardrails. We also know this is a global issue and believe the same rules should apply to stablecoins and are working to help create that consistency.”

Global Stablecoin Regulations

Stablecoins have long been on the radar of regulators in many major economies, but the UST collapse acted as a catalyst, forcing U.S., South Korean and many European regulators to take note of the vulnerability of these volatile digital assets to the U.S. dollar peg.

U.S. regulators are citing the incident as a push for tougher rules for stablecoins and their issuers, Treasury Secretary Janet Yellen Legislative plan to be announced by the end of the year.

Yellen said a “coherent federal framework” for stablecoins by the end of 2022 would be “very appropriate” given the market’s growth. She called for bipartisanship among members of Congress to create legislation for such a framework.

These can easily be imposed on collateralized stablecoins such as USD Coin (USD/USD) and USDT, which are backed by traditional-style treasuries and held by centralized entities.

Max Kordek, co-founder of blockchain development platform Lisk, believes the collapse of the UST will be used by lawmakers to push for a central bank digital currency (CBDC). He told Cointelegraph:

“As a result of this incident, trust in algorithmic stablecoins may be significantly reduced and it will take some time to restore trust. Unfortunately, this will be used by politicians as an example of why the world needs a CBDC. We don’t need a CBDC; however, we What is urgently needed is a reliable, decentralized stablecoin.”

Congressional Research Service, a legislature that supports the U.S. Congress, Published a report on algorithmic stablecoins Analyze UST crashes. The research paper described the LUNA crash as a “run-like” scenario that resulted in multiple investors withdrawing funds from the ecosystem at the same time.

These situations in the traditional financial sector are protected by regulations that guard against such situations, but the absence of any regulation could lead to market instability in the crypto ecosystem, the research report states.

Jonathan Azeroual, vice president of blockchain asset strategy INX, told Cointelegraph:

“If investors lose faith in the mechanisms created to ensure their stable value, or simply the assets backing them are worth less than issuing stablecoins.”

He believes that the U.S. government will certainly try to strengthen its power to regulate stablecoins, as it shows that they are not a viable solution to a regulated digital economy.Regulators may require “stablecoins to be issued or regulated as securities by federally regulated banks, which would expose them to SEC oversight [Securities and Exchange Commission]. “

David Puth, CEO of the Center Consortium, founded by Coinbase, wants constructive regulations after the collapse of the UST. He told Cointelegraph:

“The fact remains that stablecoins are a critical part of the growing crypto ecosystem, and industry groups in the U.S. have been expressing their desire for clear and constructive regulation.”

Puth wants a “thoughtful, innovation-friendly regulation that keeps the U.S. at the forefront of the blockchain economy.”

Besides the U.S., South Korea is another country that got serious about stablecoins after the Terra crash. Do Kwon, founder of Terra was summoned to the country’s legislature for a hearing. Korean regulators have also started Risk assessment of various crypto projects operate domestically.

key lessons

While regulatory discussions around stablecoins have accelerated due to the UST debacle, it also underscores that the crypto market has grown big enough to absorb $40 billion in losses. This is proof that the cryptocurrency market has grown enough to absorb a setback as big as Terra without posing a threat to broader market stability.

It must be noted that the collapse of Terra and the overall market correction resulted in a cascade of secondary effects such as increased foreign exchange outflows, a surge in liquidations (most notably derivatives and decentralized finance), and at least a temporary slowdown in DeFi (total value locked and reduced activity), and liquidity staking issues.

Thomas Brand, institutional head of Finnish virtual asset service provider Coinmotion, told Cointelegraph:

“I think regulators are particularly interested in how the risks of cryptocurrencies, especially stablecoins, affect TradFi and CeFi through contagion and (intra) direct exposure. So far, these risks have not been systematically realized. Nonetheless, regulators There will likely be more focus on these issues soon — mainly if they conclude that at least some stablecoins are reminiscent of a kind of shadow banking.”

Terra is not a systemic risk at this point, but its collapse is limited, although impacts can be seen in various interconnected ecosystems.

Derek Lim, head of crypto insights at Bybit exchange, told Cointelegraph that while the UST crash did attract scrutiny from regulators, the crypto market managed to recover without seeing massive losses across the board. He explained:

“I would like to point out that one of the main concerns that U.S. regulators have made clear in several reports is that a stablecoin bank run could disrupt the wider financial system. This incident demonstrates a bank run on the third-largest stablecoin by market capitalization. Little to no impact on the broader crypto market, let alone the S&P and beyond.”

Terra’s spiral disaster highlights not only the need for transparency by stablecoin issuers, but also the importance of regulated markets. With clear rules in place, there are several gatekeepers to prevent small investors from losing money. The incident has caught the attention of regulators around the world.

The Terra debacle could prove to be a turning point in global stablecoin regulation, much like what Libra’s global stablecoin plan did with a CBDC — prompting regulators to speed up their own plans.