It’s been a downward slide for the crypto markets in the first half of 2022. You can blame it on several factors, but stablecoins have played a key role in the downdraft.
Even before the TerraUSD stablecoin meltdown in May, both crypto and equity markets were in sell-off mode thanks to headwinds from inflation, rising interest rates and the war in Ukraine.
The high-profile collapse of TerraUSD was like gasoline on a fire. The total cryptocurrency market cap has been chopped in half since May, falling from around $1.7 trillion to about $900 billion as of late June.
Experts believe crypto winter has arrived, and also say it could provide a necessary corrective to weed out the bad actors that mushroomed during the crypto market’s bull run in 2021.
Some of those bad actors were among the stablecoins, which have become a major pillar of crypto. They help to facilitate trading, serving as a bridge to more volatile crypto assets.
The catastrophic meltdown that happened virtually overnight to TerraUSD exposed the failings of some parts of the stablecoin market, particularly so-called “algorithmic” stablecoins.
How Stablecoins Work
In cryptoland, stablecoins aims to provide a “safe” digital asset that maintains a stable valuation.
The value of a stablecoin is pegged to the price of another asset, most commonly a fiat currency like the U.S. dollar. The goal is for the stablecoin to maintain the same value as its peg.
With a dollar peg, one stablecoin should always be valued at one dollar, no matter what’s happening elsewhere in the market.
Both Tether (USDT)—currently the third-largest cryptocurrency by market cap—and its fellow stablecoin USD Coin (USDC) are pegged to the U.S. dollar. When you buy $10 of USDT, you expect it to be worth $10 tomorrow and $10 one year from now.
Algorithmic Stablecoins Are Anything But Stable
TerraUSD was an entirely different beast than either Tether or USD Coin. It was an algorithmic stablecoin, backed by nothing more than the magic of computer code.
Nevertheless, TerraUSD aimed to maintain a stable value of one dollar—the computer code mentioned above would inject and withdraw its sister coin, Luna, from the market to maintain TerraUSD’s stable value.
This algorithm-driven system had no foundation in U.S. dollars or other real assets, making it easy prey for savvy short sellers. Perhaps you begin to understand how things could have gone south so quickly.
“In early May, when Terra lost its peg, there was a rush to draw a line in the sand between algorithmic stablecoins and centralized stables that back their coins with cash or cash equivalent reserves, like USDT and USDC,” says Ross Fedenia, a CFP and managing director of Atlatl Advisers.
TerraUSD became depegged from the U.S. dollar on May 9, but you can still buy TerraClassicUSD (USTC). After the depeg, Terra’s co-founder Do Kwon proposed a revival plan where USTC could run on the old Terra blockchain. USTC, however, is, in essence, a defunct stablecoin that trades around a penny these days.
The U.S. Securities and Exchange Commission (SEC) is reviewing details of Terra’s collapse and whether the marketing of TerraUSD violated federal investor protection regulations.
Hedge Funds Are Shorting Tether
With the implosion of TerraUSD, other stablecoins are under a microscope, particularly Tether. Tether’s market cap has fallen over $15 billion since early May, CoinMarketCap.com’s data shows.
Skeptics allege that the organization that runs Tether does not have the collateral in assets to back its full market cap, which is currently $66 billion.
Tether’s chief technology officer Paolo Ardoino said there are hedge funds out to short Tether in a 12-part Twitter thread on June 27.
Ardoino tweeted: “These hedge funds believed all the FUD spread by the truthers in the past months/years: they believe/d that Tether was/is no 100% backed.”
The crumbling of TerraUSD and other crypto firms also sparked the interest in hedge funds to short Tether.
“The fear, uncertainty and doubt surrounding Tether’s lack of transparency on reserve has been in existence since its inception,” says Gritt Trakulhoon, lead crypto analyst at Titan. “It has been amplified recently with all the headlines surrounding the collapses of Terra, Celsius and Three Arrows Capital.”
According to Trakulhoonh, funds that are shorting Tether aim to amplify fear and raise pressure on the stablecoin to drive cascading outflows. This would impair Tether’s liquidity—and the short traders could then eventually buy back USDTs at a much lower price.
These funds are betting against Tether because of its lack of transparency in showing audited reserves. But if USDT is fully backed, Tether has nothing to worry about.
“Tether may be able to shut down these attacks by being very transparent on where their reserves are invested. Until then, the redemptions seem likely to continue and public confidence may continue to erode,” Trakulhoon says.
The market is clearly showing us that collateralized stablecoins are the future, says Andrew Pesco, head of investment management at Domain Money.
Collateralized stablecoins like USD Coin have proven resilient these past two months. USDC’s market cap since early May has risen 12%, growing to a total market value of about $55 billion, according to CoinMarketCap’s data.
“The data doesn’t lie: It can be clearly seen that people are switching over to USDC,” Trakulhoon summarizes.
Stablecoin Regulations Are Coming
The unwinding of TerraUSD caught the attention of U.S. Treasury Secretary Janet Yellen, who has started talking about the possibility of stablecoin regulations.
According to Yellen, a regulatory framework is needed to guard against stablecoin risks.
“We’ve allowed “experiments” like TerraUSD to dominate and grow significantly beyond where they naturally should sit given their inherent risk,” says Alex McDougall, CEO of Stablecorp, who agrees that aggressive regulation is a net positive for digital assets.
Earlier this month, Sen. Kirsten Gillibrand (D-NY) and Sen. Cynthia Lummis (R-WY) introduced a bipartisan bill, dubbed the Responsible Financial Innovation Act, which looks to regulate “payment stablecoins.”
“It includes tax requirements for various digital assets, and imposing stricter requirements for stablecoins, which, according to Gillibrand, would have disallowed the TerraUSD coin,” says Fedenia says.
The bill also includes provisions about cybersecurity and the possible creation of a self-regulatory organization and some disclosure requirements.
“But perhaps most importantly—and the thing that has skeptics most concerned—is that the bill defines most cryptocurrency as commodities, which would be overseen by the Commodity Futures Trading Commission (CFTC), instead of securities, which would fall to the much bigger SEC,” Fedenia says.
The bill has been read twice and referred to the Senate Finance Committee, and is not expected to be voted on until later this year.
More From Advisor
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.