Has the recent collapse of the stablecoin UST and its crypto token twin LUNA seriously set back the rapidly expanding world of cryptocurrencies? Media moralizing notwithstanding, we believe that the Luna lapse represents a bug, not a feature, of stablecoins related to the organizing principle of its support mechanism. The steady value of one unit of UST to the US dollar was to be maintained by algorithmically purchasing (or selling) it when the price was below (or above) par with the matched dollar proceeds (or obligations) of the opposite transaction in the varying-value crypto token LUNA. However, relying on a varying-value token to support a stablecoin is akin to attempting to defend a fixed exchange rate with reserves made up entirely of the local-currency-denominated sovereign debt. At a time of stress, a run on the parity of the defended obligation triggers a run on the reserve asset. The price can only be reliably supported with a stock of assets valued outside the defense perimeter, which is why traditional reserve managers obsess about holding liquid hard currencies. Likewise, we believe investors should scrutinize the asset holdings of issuers of stablecoins more than the coding of their algorithms.
That said, the episode cast a considerable shadow, as investors withdrew from the asset class, lowering the market value of crypto tokens and the firms that hold and trade them, and we should draw as many lessons as possible. We offer three.
First, the price dynamics throughout the crypto complex show that contagion can be powerful, and they work through four main mechanisms.
1. Forced Selling: The UST managers appear to have sold more varying-value tokens than LUNA, apparently Bitcoin, in defense of UST, depressing its price.
2. Cross Hedging: Speculators wanting to capitalize on the price spiral of UST and LUNA took similar positions in other stablecoins and tokens, moving their prices even though they were bystanders to the original drama.
3. Common Holders: Following standard risk management procedures, those suffering losses from UST and LUNA cut exposures to the other assets in their portfolios across the board, depressing values generally. For those investors using leverage, the need to post additional margin reinforced this mechanism. We believe the original wealth loss was probably significant enough to spill over to other, more traditional, asset classes.
4. Common Reputations: Reputation damage to the UST/LUNA business model influenced investors’ perception of (and risk aversion toward) other stablecoins. This was probably worsened by information asymmetries that are rife in the market. Uninformed market participants took a signal from price declines in UST/LUNA driven by better informed participants fleeing from somewhere and fled themselves— from everywhere.
Related to that last aspect of contagion, the second lesson came when Tether (USDT) temporarily broke the buck, trading as low as 95 cents on the dollar, after large outflows when the standing of stablecoins slipped in investors’ esteem. If reserves are not liquid (and the opacity of Tether’s balance sheet does not help), then a run cannot be beaten back immediately. This experience has probably fed investors misgivings about stablecoins, lowering the hurdle for subsequent runs.
The third lesson is that progress toward a more stable financial system sometimes follows a bumpy road. After the drama of the past week, the private sector probably views the crypto complex more warily, which lowers values and adds to the volatility of prices therein. This is not obviously detrimental to financial stability. More importantly and of more lasting import, the crypto crash has likely energized official scrutiny of the sector. Here, again, this may be good for financial stability because official sluggishness, especially in the US and related to the fragmented and overlapping set-up of regulation, has been an impediment to progress. The Federal Reserve (Fed), for example, only issued a consultative document on central bank digital currency for public comment this January. Established firms take careful consideration when entering a market segment that could subsequentially made more hostile by regulation. The result is a proliferation of smaller and start-up participants encamped in the crypto landscape. It appears crypto is now a bigger bogy on the regulatory radar, perhaps ultimately bringing more order and opportunity when some flight controllers get on the job.
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