The Stablecoin Contagion That Wasn’t

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A rare, recent real-life test case allowed observers to contrast government warnings with real-world events.

Reining in cryptocurrency markets has become a key priority for Biden administration financial regulators. In March the president signed an executive order seeking “responsible development” of crypto innovation. Last November, a President’s Working Group (PWG) composed of financial regulators published a report warning of dire consequences if a crypto category known as stablecoins isn’t placed under a federal regulatory umbrella soon. Stablecoins are digital assets pegged to a stable monetary value, usually the U.S. dollar.

The report came laden with doom and gloom, or FUD in crypto speak, for Fear Uncertainty and Doubt. One PWG concern was that a large-scale stablecoin failure could spark a “run” and a general economic calamity:

Failure of a stablecoin to perform according to expectations would harm users of that stablecoin and could pose systemic risk. 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.

In a recent speech, Securities and Exchange Commission (SEC) Chairman Gary Gensler, a PWG member, echoed these concerns:

[S]tablecoins are so integral to the crypto ecosystem that a loss of the peg or a failure of the issuer could imperil one or more trading platforms, and may reverberate across the wider crypto ecosystem.

The risks are supposedly so dire, that if Congress were to demur, the PWG requested the Financial Stability Oversight Council—created by the Dodd-Frank law—impose regulatory authority unilaterallywithout input from elected representatives.

As fate would have it, the market produced a test case for the government’s warnings. When stablecoin TerraUSD (UST) crashed spectacularly in May after losing investor confidence and losing its $1 peg, taking down affiliated crypto token Terra and the $40 billion total market cap for both cryptocurrencies in the process, all of the government’s fears seemed to be coming to fruition.

That UST was an unbacked “algorithmic” stablecoin—a type unaddressed by the PWG report—instead of an asset-backed stablecoin did not seem to matter. Treasury Secretary Janet Yellen testified: “We’ve had a real-life demonstration of the risks” that supposedly required the PWG’s suggested “comprehensive framework” to eliminate “gaps in the regulation.”

But a funny thing happened on the way to economic collapse: Nothing. Tether, the largest stablecoin, did briefly de-peg to 95 cents. And it lost $10 billion in volume as some rushed to convert their Tether dollars into fiat dollars. But amidst the chaos, Tether tweeted reassurance that anyone who wished to convert could.

The contagion crisis appears to be over. No other stablecoin issuer was touched. The biggest asset-backed stablecoins all easily withstood the shock. Today, the stablecoin market stands at $159 billion with no individual stablecoins in danger.

Academics, journalists, and policy makers will study the Terra ecosystem collapse in the months and years ahead. Clearly, no one has “cracked the code” for sustaining an algorithmic stablecoin under severe market stress. Other stablecoins and cryptocurrencies may fail, but the Terra collapse shows that a contagion taking down the entire crypto market is extremely unlikely, particularly for asset-backed stablecoins that attest to their reserves. But that is not a government concern. An intrusive federal framework will inhibit, not help, stablecoin stability.