How stablecoins are destabilising crypto

This is a guest post by Robert McCauley, non-resident senior fellow at the Global Development Policy and an associate member of the Faculty of History at the University of Oxford.

The fate of the stablecoins is fateful for the whole crypto complex. This follows not from their size but from the essential liquidity role they play.

To finesse the technical and legal difficulties of transactions between crypto and real dollars, the crypto market has devised its own near dollars. These serve as the vehicle currencies in crypto trading, providing crucial liquidity and collateral services. The main cryptocurrencies, bitcoin and ether, are bound to be worth much less in a trading environment with impaired stablecoins. As the largest stablecoin fights for its life, it is not too soon to step back and consider what is at stake.

From euphoria to distress . . . 

At its peak valuation of $3tn in early November, the crypto mania enjoyed euphoria to moon. Operating to a considerable extent in a legal no man’s land, the mania provided more incentive than most for market players to invent its own money and to build its own structures of credit and leverage.

The crypto universe made the transition from euphoria to distress in the months since the peak of prices. Distress is also known as the Wile E. Coyote moment, when the cartoon character has run over the side of the cliff and by Warner Brothers physics does not fall until he looks down. Distress is characterised by those with more insight moving to lay hands on real cash.

The movement to cash by the non-HODL (“hold on for dear life”) crypto holders acted to push down crypto prices. Yet stablecoins not only held their price but also continued to grow in aggregate size. In October 2021, they weighed in at $127bn, over half of which was by market leader tether.

Stablecoins reached an aggregate measured value of $180bn at the end of February. It held around that level into May. In retrospect, what is odd is how the stablecoins continued to motor along, Wile E. Coyote style. Distress belatedly hit stablecoins last week.

Though here are multiple stablecoins the top four, tether (USDT), USDC, BUSD and terra (UST) amount to 90 per cent of the market. Respectively, their percentage shares are 46, 24, 10 and 10.

What is the order of play? In 1992, the testing of the Exchange Rate Mechanism spiralled from the small and peripheral to the centre. The Finnish markka was picked off first, then the lira and pound were attacked, and finally the French franc. Likewise, the first stablecoin in the sights was in the periphery.

Terra had three strikes against it: size, algorithmic construction and high interest rates. On size, UST’s growth saw it nose ahead of BUSD just last month.

Many readers are familiar by now with the difference between an algorithmic and a backed stablecoin, though the difference is still worth defining. The latter is (or claims to be) an unregulated money market fund. Its pseudo-dollars are backed with something like cash: bank deposits, Treasury bills and commercial paper. Long stretches of stable outstandings raise questions around how the price of tether been stabilised: is it through (legally delayable) redemptions by tether, market operations by its operators, or stabilising speculation by others?

Terra, an algorithmic stablecoin, claimed to be superior in not having such a foot in traditional finance. After all, a government can seize such assets, or make it difficult for dealers to buy and sell them. Stable terra derives its stability from preprogrammed trading against a floating token, luna. If Terra falls below par, a trader can buy it at a discount and use it at par to buy a dollar’s worth of luna, whatever luna’s price. After selling the luna, the trader pockets the discount.

But support for terra’s par value depended on operations that expanded the supply of luna, so faltering demand meant prices gapped downwards and turned the sure-thing arbitrage into a loss.

The interest on UST was the third strike. The terra-luna set-up included the Anchor (why not Acme, the mail-order source of Wile E Coyote’s clever devices?) Protocol paying 19 per cent APY. And whenever you hear someone talking about 19 per cent yields on an asset promising a stable value against the dollar, put your hand on your wallet.

In addition to being not obviously sustainable, this rate attracted most outstanding UST to one, visible place. Anchor had deposits of a record UST 14bn on Friday (out of $18bn outstanding), but just 9bn UST on Monday and 2.6bn at pixel time. The transparency of the deposit total could only help if any co-ordination among depositors were required. Big sales on exchanges sent UST’s price below par and signalled that the bots would be pumping out luna.

An analogy is a fine piece of financial engineering from the 1980s: par reset junk bonds, which formed part of KKR’s 1989 buyout of RJR Nabisco. The coupon on these bonds was to be periodically reset to bring the securities to par. Once RJR Nabisco’s finances became distressed, an interest rate that would bring the bonds to par would bankrupt the company. Only KKR bringing new equity to the deal prevented the firm’s finances from blowing up.

UST’s wily not-so-decentralised organisers had already begun to prepare their creation for its test by buying bitcoin to back it. So far, the suggestion that they have committed some part of their reported $3.5bn in bitcoin holdings to UST’s defence did more to unsettle bitcoin holders than to prop up UST.

. . . to panic and crash? 

It was fair to point out, as some did earlier this week, that backed stablecoins are different. No doubt they are not as inherently unstable as algorithmic stablecoins. Nevertheless, the path from UST to USDT was as short as D, as in Distress. Distress is when some sharpen their perception of the difference between recently invented near-cash and the real thing and act. Margin calls can move this process along.

It is not that USDT is unregulated. In 2008, the Primary Reserve Fund proved that SEC regulation was not proof against a money-market fund breaking the buck. And March 2020 showed that runs can hit money market funds even without any breaking of the buck. If stablecoins should become banks with capital, perhaps Paul Volcker should have recommended the same for money market funds in the late 1970s.

Rather, Tether is a “company that seemed to be practically quilted out of red flags”. The Businessweek cover story from last October bears rereading: a leading glossy shouted fire, but the crowded theatre’s patrons stayed in their seats. Outrage greeted tether’s first circle-chart of its holdings released the previous May.

Guesses as to the obligors and nature of tether’s reported holdings of commercial paper vary. Is it paper issued by distressed Chinese real estate developers? IOUs backed by cryptocurrencies? (How might those margin calls be going?) Or worse? The mélange might make the Lehman Brothers commercial paper that broke the buck at the Primary Reserve Fund in September 2008 look pretty solid. If we are witnessing the torschlusspanik, the oddity is how long it took.

The stablecoin crypto vehicle

It might seem that stablecoins are a sideshow. Their market capitalisation at the end of October 2021 was less than 3 per cent of the crypto market. The share has risen since, but still is not large.

Nevertheless, the trading and thus the liquidity of the crypto market depends on stablecoins. In particular, decentralised finance runs on stablecoins. Tether’s $80bn-plus market capitalisation is now about a tenth of the joint market capitalisation of bitcoin and ether, but its measured daily trading volume is higher than their joint turnover.

Price discovery for bitcoin takes place in derivatives trades where tether serves as the margin and settlement currency. What trading of the dollar against the euro is to currencies, trading of bitcoin against tether is to crypto. On the Binance exchange, the pricing of reassuringly named perpetual swap contracts involving bitcoin and tether drives bitcoin prices in US dollars and more broadly influences prices across crypto.

Without tether, or at least without stablecoins, it is not clear how the crypto complex functions. Problems with the vehicle currency would impair the liquidity of the whole crypto complex, just as the “dollar shortage” of late 2008 impaired the liquidity of the whole foreign exchange market. Less liquid assets are worth less. And if a prominent stablecoin becomes essentially a worthless entry on nobody’s spreadsheet, it would suggest other crypto could go to zero.