Stablecoins losing stability – is Tether losing its peg too?
Senior Quantitative Analyst, Saxo Bank
Summary: Over the past couple of days, UST, one of the major crypto stablecoins, completely lost its peg with the US dollar, and today the biggest stablecoin, Tether, has shown signs of a similar trend. In this article, we zoom in on the difference between three of the biggest stablecoins and discuss the potential impact that de-pegging may have on the general crypto market.
- co-written by Mads Eberhardt, Cryptocurrency Analyst
Stablecoins are crypto tokens that have their value pegged to another currency or asset. The most popular stablecoins are USDT (Tether), USDC, and UST (Terra), which all are created to have the value of $1. Apart from providing crypto traders with a store-of-value within the crypto space linked to fiat currencies, stablecoins play important roles in many of the decentralized applications build on blockchain technology and cryptocurrencies.
The crash of the Terra stablecoin in the beginning of the week has shaken the crypto markets, and UST is currently trading at $0.60 - way below $1.00. This morning the contagion spread to the rest of the stablecoin space with USDT dropping as low as $0.96, however bouncing back to $0.99 this afternoon. It should be noted that other stablecoins are trading above $1.00 as they seem to be receiving value from some of the unpopular stablecoins.
To understand why the stablecoins are suddenly not stable anymore, it is crucial to understand the collateral type for the different stablecoins. We focus on the three mentioned above.
Terra (UST) relies on a swap function to maintain its peg through an associated crypto token, LUNA, as 1 UST can always be swapped for $1 worth of LUNA. We elaborate more in the appendix below. But in short, UST is not collateralized by anything other than the market’s belief that LUNA will always have value to some and thus always have interested buyers, and this belief is anyway closely related to the value they see in UST. This belief from the market in LUNA is exactly what is missing right now, disabling the pegging mechanism. During Terra’s recent rally, many also criticized Terra for basically being non-collateralized due to this structure, as it does not have any backing in physical assets.
The second-largest stablecoin USDC is, however, backed 100 % by reserves in cash and cash equivalents such as short-term highly liquid investments. This is fundamentally different from the collateral in UST, and USDC is thus seen as a much more stable peg to the US dollar.
The largest stablecoin, Tether, does reportedly have around 85% of its reserves in cash and cash equivalents and the rest in other assets such as corporate bonds and other digital tokens. However, Tether has earlier faced controversies when it comes to transparency around its dollar reserves, so the market has for years questioned what assets its reserve consists of and whether Tether in reality keeps full reserve to back its stablecoin.
These controversies are likely what is driving stablecoin investors away from USDT, as the event of UST has refreshed the market’s memory of Tether’s lack of transparency with respect to its reserve. The sell-off in USDT this morning occurred even after the CTO of Tether posted on Twitter that they were continuing to honor USDT redemptions at $1 and that the redemption of more than $300mn has been carried out over the past 24 hours. And as it looks for now, Tether is making a comeback towards the $1.00 level.
Regulators may become more harsh
The whole narrative of Bitcoin and especially stablecoins is now heavily under pressure, although it is important to emphasize that not all stablecoins are currently under pressure – only those where investors doubt the collateral mechanism. But it is not only investors, who are worried. Regulators and policymakers are still working on national and international regulations for the cryptocurrency space, and fear is now that the regulatory framework will be even more strict, and it could limit some of the existing use-cases for cryptocurrencies. In case potential applications for cryptocurrencies are constrained, the sentiment will likely go down as well.
Appendix - Additional reading for those interested in the Terra:
Terra had over $18bn worth of stablecoin issued prior to the bank run of its stablecoin. For Terra, there are two tokens. Its stablecoin called TerraUSD (UST) and LUNA. LUNA has no value other than the fact that you can always create and redeem 1 TerraUSD (intended to be worth $1) for $1 worth of LUNA and vice versa. When you create TerraUSD, the LUNA is burnt and TerraUSD is created. When you redeem TerraUSD, it is burnt and LUNA is created.
Since you are paying or receiving $1 worth of LUNA for every TerraUSD you create or redeem, people are intended to arbitrage, so TerraUSD is as close to $1 at all times. For instance, let us say TerraUSD falls to $0.95. By buying TerraUSD at $0.95, you can technically redeem it for $1 worth of LUNA, selling it for fiat and earning 5 cents. As mentioned above, TerraUSD is not collateralized by anything other than the market’s belief that LUNA will always have somewhat of a value, which belief is anyway closely related to TerraUSD.
Since Terra started gaining momentum last year, people have criticized this structure, as it is basically non-collateralized. The Terra foundation responded by buying $1.5bn worth of Bitcoins at the beginning of this year to show some collateralization. This means that Terra was suddenly solely around 10% collateralized in another highly volatile asset and due to the fact that the foundation controlled the small collateralization there was, Terra was suddenly not that decentralized.
Over the weekend, some traders started selling a lot of TerraUSD to un-peg it from the dollar, among some other things. When the un-peg occurred, people started to redeem TerraUSD for $1 worth of LUNA and sell LUNA to fiat to cover their position. This LUNA is created by new and when dumped on the market, the price of LUNA plunges. When the next redeems TerraUSD for LUNA, they need to get credited by even more LUNA. Suddenly not only TerraUSD holders are pushing the LUNA price down, but other traders see it and go short LUNA, pushing the price further down.
Now, you have the death spiral. LUNA plunges even more, while more and more LUNA is needed to be issued to redeem one additional TerraUSD. At the same time, there is a cap on how many can redeem TerraUSD to $1 worth of LUNA per hour. People that cannot redeem it start to get nervous and dumps TerraUSD directly to USD or other assets on exchanges, de-pegging it further from $1. As this happens, few want to do arbitrage, because they cannot instantly redeem it for LUNA and sell it for fiat since there is a maximum the protocol can redeem per hour.
LUNA's supply has increased 20-fold in the past few days from around 346mn to 7.1bn LUNA to redeem some of its TerraUSD supply. At the same time, its market capitalization has plunged by over 99%. LUNA currently has a market capitalization of $138mn, but technically it still needs to redeem 12bn TerraUSD for $1 each. This means that LUNA is going through hyperinflation, if it will be possible to redeem every UST at all since there is close to no demand for LUNA.
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