Terra Troubles Should Not Spur Stablecoin Regulation

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The crypto market is suffering a severe correction. One asset feeling the pinch is LUNA, which, along with its related nonprofit the Luna Foundation Guard (LFG), governs and support the stablecoin TerraUSD (UST).

UST is an algorithmic stablecoin. Instead of being backed by assets such as U.S. dollars, government securities, or commercial paper, it backed by the volatile digital asset LUNA. Users can theoretically always exchange $1 of LUNA for $1 of UST, which is how it maintains it dollar peg. But this depends on LUNA being valuable enough to support the exchange. According to CoinDesk, the Terra crypto ecosystem has dropped 53 percent in the past 24 hours. This has caused UST to drop as low as 35 cents. At as of this writing, it is trading around 70 cents.

UST is fighting for its life and it’s anyone’s guess whether LFG’s moves to save it, including lending out $1.5 billion in Bitcoin to support the peg, will be enough.

Importantly, other stablecoins are holding their $1 peg, including DAI, which is tied to Ether, the second largest digital asset. In fact, despite the absolute bloodbath that May has become in crypto markets, stablecoins have proved resilient.

Nonetheless, under the familiar political mantra “Never Let a Crisis Go to Waste,” Treasury Sectary Janet Yellen seized on UST’s troubles to call for stablecoin regulation yesterday in Congressional testimony, stating that current regulations “don’t provide consistent and comprehensive standards for the risks of stablecoins.”

But before Congress leaps blindly into reactive stablecoin lawmaking, some perspective is needed. First, the President’s Working Group (PWG) report on stablecoins, released last November, do not even cover algorithmic stablecoins like UST, as Sen. Pat Toomey (R-PA) reminded Sectary Yellen. As the PWG report described, these stablecoins are a niche subset that have not gained the importance of what the PWG called “payment stablecoins”—those backed by real-world assets like U.S. dollars and treasuries.

Thus, the PWG’s recommendation, that stablecoin issuers become federally chartered banks insured by the Federal Deposit Insurance Corporation would not apply.

Second, even assuming the PWG report did have aspects that applied to algorithmic stablecoins, the parade of horribles the PWG report envisions has not occurred. The PWG warned of stablecoin runs turning systemic and even threatening the broader economy:

The mere prospect of a stablecoin not performing as expected could result in a “run” on that stablecoin – i.e., a self-reinforcing cycle of redemptions and fire sales of reserve assets. Fire sales of reserve assets could disrupt critical funding markets, depending on the type and volume of reserve assets involved. Runs could spread contagiously from one stablecoin to another, or to other types of financial institutions that are believed to have a similar risk profile. Risks to the broader financial system could rapidly increase as well, especially in the absence of prudential standards.

Third, the entire stablecoin market stands at a relatively miniscule $173 billion. The Federal Reserve’s, Financial Stability Report, released on May 9, claims the total asset market vulnerable to runs stands at $19.1 trillion.

Congress should be wary of creating another financial regulatory disaster like Dodd-Frank, as reactive measure to a market correction.

If UST falls, it should be a lesson for traders in backing a stablecoin with a relatively unproven reference asset and outlandish yields. Of course, people should be able to bet on riskier assets, but their failure should not trigger a congressional response.