Stablecoins: The Collapse of TerraUSD and the Road Ahead for the “Less-Risky” Form of Cryptocurrency

Stablecoins—a digitally native medium of exchange that seeks to maintain a stable relative value—have seen explosive growth in recent years as they’ve become increasingly used not only for trading and payments but also in burgeoning decentralized finance (or DeFi) ecosystems. In light of recent activity in one prominent stablecoin—TerraUSD—this piece takes a closer look at stablecoins and examines some potential legal and regulatory issues they present.¹

Stablecoins: What are they, and what are they designed to do?

The Bitcoin whitepaper, published in 2008, was titled “Bitcoin: A Peer-to-Peer Electronic Cash System,” yet volatility in the price of Bitcoin in the intervening years has inhibited its adoption as a means to exchange money and, for the risk-averse, as a means to store value. For example, a merchant would likely be reluctant to accept Bitcoin in exchange for goods or services if the value of the Bitcoin paid could drop drastically only moments after the exchange was completed. Most cryptocurrencies created since Bitcoin share this price volatility, which may make cryptocurrencies attractive to traders and speculators but more challenging to use in many other circumstances. Enter the stablecoin, a type of cryptocurrency that is designed to achieve price stability through linking its market value to a reference asset, most often the US dollar. By linking or “pegging” to this more stable reference asset, the stablecoin can then be used in scenarios where price stability is the primary objective, such as for peer-to-peer or cross-border payments, in the on-chain trading of other digital assets, and in collateralized lending and other DeFi services.

To date, most stablecoins have been designed to represent a fixed amount of US dollars (or other fiat currency) in a purely digital format. According to CoinMarketCap, a recent estimate of the stablecoin market capitalization was approximately $167 billion (as of May 13, 2022), out of a wider cryptocurrency market cap of $1.29 trillion.² While this may seem only a small portion of the wider cryptocurrency market, the growth in this area has been explosive, with a close to 3,000% increase since the start of 2020.³ This has coincided with the growth of DeFi more generally, which has seen total valued locked (TVL) increase by almost 30,000% over the same period.⁴

However, while all stablecoins offer the promise of stability in price, not all are able to achieve this outcome. In order to understand why this is the case, it’s helpful to start by examining the way stablecoins are designed. Stablecoins generally fall into two broad categories: custodial and non-custodial (or “decentralized”); each broad category can also have sub-categories, which are also described below.

Custodial Stablecoins

The most common form of stablecoin is the custodial stablecoin, which is collateralized by off-chain collateral assets held in reserve by a centralized entity that issues the stablecoins—referred to as the “stablecoin issuer.” These collateral assets are most frequently denominated in fiat currency (the vast majority of custodial stablecoins are pegged to the US dollar and collateralized with US dollars or dollar-denominated assets—more on that below). As a result, this discussion will be focused on the fiat-backed variety of custodial stablecoins, though there are other types of custodial stablecoins, which are collateralized with physical stores of commodities such as gold or oil instead of fiat currency. In these commodity-backed stablecoins, the physical commodity itself is stored securely and may be audited to confirm the existence and amount of the commodity collateral.

The mechanism of a custodial stablecoin can be compared to a poker chip, where each dollar represented in a poker chip is exchangeable for an equivalent amount of dollars in cash at a 1:1 ratio. A poker chip “purchased” in this way can then be used within the “ecosystem” of the casino, similar to how custodial stablecoins can be exchanged within the crypto financial ecosystem. To cash out a poker chip, the player simply walks to the cashier and exchanges its chips for cash—similarly, in a custodial stablecoin, the stablecoin holder can go back to the stablecoin issuer and redeem its stablecoins for fiat currency.

To allow for this type of exchange, the stablecoin issuer must ensure that it has enough collateral in reserve so that every holder that wants to cash out can get paid an equivalent amount of fiat currency for each stablecoin they hold. To enable this, a stablecoin issuer may hold in reserve an amount of fiat currency that is equal to the amount of stablecoins in circulation. But a stablecoin issuer may also invest some of its reserves in highly liquid assets that can be easily exchanged, such as treasuries, short-term commercial debt, or interest-earning bank accounts. (The ratios of fiat currency to other liquid assets held by different stablecoin issuers is not always publicly known.)

Significant examples of fiat currency stablecoins include Tether tokens (USDT), USD Coin (USDC) and Binance USD (BUSD), which are currently the top three stablecoins by market capitalization and represent the vast majority of total stablecoin volume. These stablecoins offer the promise of stability and reliability, provided that the stablecoin issuer is trustworthy and transparent.

Not all custodial stablecoins engender the same level of trust or provide the same level of transparency, however, and one of the features of blockchain technology is the ability to disintermediate and remove the need for trust in centralized parties. The second general class of stablecoins—non-custodial or decentralized stablecoins—seeks to leverage blockchain technology to do just that.

Non-Custodial (or Decentralized) Stablecoins

Non-custodial stablecoins were created to achieve the same objective as custodial stablecoins (i.e., price stability), though without the need for a trusted third party. They rely on smart contract code operating on public blockchains and incentive-based economic design that, assuming the participation of rational and independent actors, is intended to achieve price stability.

There are generally two types of non-custodial stablecoins: collateralized and uncollateralized (often called “algorithmic”). While there are also some variations that fall in between (i.e., partially collateralized) and take design cues from each type, we focus the discussion below on the two ends of the spectrum.

Collateralized Non-Custodial Stablecoins:

Non-custodial collateralized stablecoins use other crypto assets as collateral rather than the more traditional (and, frequently, less volatile) assets that back custodial stablecoins. These stablecoins use smart contracts to custody other crypto assets such as ether (ETH); the smart contracts take the place of a central stablecoin issuer.

Because these assets are more volatile, over-collateralization is typically required to maintain price stability. Rather than depositing $1 with a centralized party to receive 1 unit of a custodial stablecoin from the stablecoin issuer, the user can, for example, deposit $2 worth of ETH in the smart contract and be automatically issued 1 unit of stablecoin. If the price of ETH falls below a certain liquidation threshold, the smart contracts are programmed to automatically liquidate the ETH that is custodied to ensure there is always sufficient collateral to cover the liability. The most prominent example of this category is DAI, which is issued by the Ethereum-based MakerDAO protocol.

Decentralized stablecoins present a number of operational risks by virtue of their structure. For example:

• The “oracle” (i.e., the data feed that feeds the smart contracts the on- or off-chain information necessary to self-execute) that tracks the exchange prices of the various collateral assets could fail, resulting in the system being unable to price assets accurately.
• The liquidation thresholds may be set too low to account for the volatility in the underlying collateral, causing untimely liquidation.
• The blockchain on which the stablecoin operates may fail, which would likely terminate any mechanisms to recover collateral.
• The chosen collateral assets could experience a failure unrelated to the stablecoin, which would also leave the stablecoin holder without access to collateral.
• The smart contracts themselves could be hacked, potentially draining collateral and leading to the insolvency of the stablecoin.

If such a system is well-designed, the smart contracts tested, and the parameters well-managed, the protocol can maintain stability at the expense of capital efficiency (through over-collateralization).

Uncollateralized (or Algorithmic) Non-Custodial Stablecoins:

Uncollateralized stablecoins attempt to solve not only the centralization problem of custodial stablecoins but also the capital efficiency problem of over-collateralized non-custodial stablecoins. As a result, these uncollateralized, or algorithmic, stablecoins typically do not use any exogenous assets—physical or digital—for collateral. Instead, they rely on internal “assets” and smart contracts to expand and contract the number of stablecoins in circulation in order to respond to supply and demand in the market and, in turn, maintain the stablecoin’s desired value.

In an algorithmic stablecoin, oracles monitor the trading price of the stablecoin on various exchanges. When the market price of the stablecoin exceeds the price of the fiat currency it tracks, the protocol creates (“mints”) or allows participants to mint new stablecoins, increasing supply and (in theory) causing the stablecoin price to decrease. Conversely, when the market price of the stablecoin falls below the price of the fiat currency it tracks, the protocol takes stablecoins out of circulation (or allows participants to do so), reducing supply and (again, in theory) causing an increase in the stablecoin price back toward its peg.

These uncollateralized stablecoins have all of the same risks as other non-custodial stablecoins. In addition to having those risks, they are also susceptible to crises of confidence and phenomena similar to bank runs. There have been many examples of algorithmic stablecoins that failed to maintain their pegged value, with the one most recently in the news being TerraUSD. Despite these unsuccessful attempts at creating stable, uncollateralized stablecoins, large amounts of venture capital funding continue to be invested in attempts to develop a successful, viable version of this model in order to achieve the dual goals of decentralization and capital efficiency.

Stablecoins: Why are we talking about them now?

During the week of May 11, the market value of TerraUSD (confusingly, abbreviated “UST”) fell below $1 per coin, dropping as low as $0.22 on May 11. Prior to this decline in value, UST was one of the more prominent examples of an “algorithmic” stablecoin, at one point being the 4th largest stablecoin and 10th largest cryptocurrency by market capitalization.⁵ TerraUSD used a sister token (LUNA) to give effect to the supply-demand transactions that would maintain the price stability in its stablecoin (UST). The goal of TerraUSD’s algorithm was to ensure that a user could always swap 1 UST for $1 worth of LUNA, and vice versa.

As an example:

• If UST traded above $1, arbitrageurs could buy $1 worth of LUNA on the open market and immediately exchange it for 1 UST through the protocol, which they can sell for more than $1 worth of value. That exchange would result in a quick profit for the arbitrageur but also put downward pressure on the market value of UST, thereby realigning the market value with the desired “pegged” value.
• Likewise, if UST traded below $1, arbitrageurs could buy 1 UST for less than $1 on the open market and immediately exchange it for $1 worth of LUNA through the protocol, resulting in another quick profit but, more importantly, increasing demand for UST and creating upward pressure on its market price to realign with the peg.

Alongside this supply/demand dynamic were incentives for users to use LUNA to participate in the Terra ecosystem. For example, LUNA was required to use the Terra blockchain and participate in a decentralized finance lending application called the Anchor Protocol, where investors could earn high interest rates on their UST deposits and take out loans against their holdings.

However, in early May, some very large sales of UST caused the price of UST to significantly deviate from its $1 target and, as the arbitrage mechanisms described above failed to return UST to its peg immediately, holders and arbitrageurs began to sell LUNA as well, decreasing LUNA’s price and diminishing confidence in its effectiveness as collateral. In time, this caused a type of “bank run” with holders of UST seeking to exit even at prices lower than $1, the supply of LUNA increasing exponentially, and the value of both declining precipitously. As of May 17, the values of both UST and LUNA have not recovered their previous levels, with LUNA having fallen to as low as $0.00014, from an all-time high of $119.51.⁶

Stablecoins: What’s ahead?

In light of the headlines generated by TerraUSD and the size of its market impact, one could expect increased regulatory and legislative interest in stablecoins.⁷ But even before TerraUSD’s collapse, some US regulators had already raised the question of whether stablecoin issuers should be subject to different existing regulatory regimes.

For example, in November 2021, the President’s Working Group on Financial Markets, joined by the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, issued a report on stablecoins that proposed the application of banking regulations to certain participants in the cryptocurrency markets.⁸ The report also raised questions regarding whether stablecoin activities might implicate the US Glass-Steagall Act’s prohibition against nonbanks taking demand deposits. More broadly, regulators have noted that stablecoins raise concerns regarding the demarcation of the bank regulatory perimeter. In their view, if stablecoins have attributes of traditional banking products, such as deposits, but are not subject to prudential regulation, then stablecoins’ risks might not be subject to appropriate supervision and risk management.

In addition, another federal regulator—the Commodity Futures Trading Commission (CFTC)—has brought and settled charges against Tether for making untrue or misleading statements and omissions of material fact in connection with the USDT stablecoin. According to the CFTC, Tether misrepresented to customers and the market that Tether held sufficient US dollar reserves to back each USDT in circulation with an equivalent amount of corresponding fiat currency held by Tether and safely deposited in Tether’s bank accounts. The CFTC alleged that Tether’s reserves were not fully backed the majority of the time. In settlement, Tether agreed to pay a financial penalty of $41 million.

In another example of regulator purview, the CFTC, the Consumer Financial Protection Bureau (CFPB) and the Federal Trade Commission (FTC) were identified in the President’s Executive Order on Digital Assets as responsible for consumer protection in the digital assets space.⁹ In this role, these agencies are likely to look at market-facing statements from stablecoin issuers and the maintenance of reserves.

On the legislative front, stablecoins have already been the subject of at least one significant legislative proposal in the United States. Senator Pat Toomey (R-PA) released a discussion draft on April 6, 2022, of the Stablecoin Transparency of Reserves and Uniform Safe Transactions Act (the “TRUST Act.”) The TRUST Act would apply to “payment stablecoins” as defined in the TRUST Act, which generally refer to fiat-backed custodial stablecoins, as discussed above. The TRUST Act would allow only three types of entities to issue payment stablecoins: (1) money transmitting businesses authorized under state banking laws, (2) insured depository institutions, and (3) a new type of entity called “national limited payment stablecoin issuers.” The TRUST Act would also require stablecoin issuers to disclose information about the assets backing the stablecoin, including the results of quarterly reviews by a registered public accounting firm.¹⁰

Key Takeaways

• Legislative, regulatory and legal scrutiny will likely increase as a result of TerraUSD’s failure to maintain its pegged value, regardless of how this issue is resolved.
• This scrutiny may take the form of enhanced or additional regulatory or legislative proposals, as well as possible enforcement actions.
• Based on regulatory precedent, areas of focus may include market-facing statements from stablecoin issuers and the means by which issuers maintain the market values of their stablecoins and the related reserves.
• Future regulatory attention on stablecoins is likely to account for key structural differences among different types of stablecoins, with consideration for the fact that risks inherent in stablecoins with fiat or less-volatile collateral present different risks than other types of stablecoins.
• Given custodial stablecoins’ structures, as a general matter it may be easier to regulate them than non-custodial versions. In fact, certain stablecoin issuers (such as Circle) are already regulated by agencies such as the Financial Crimes Enforcement Network (FinCEN) and under certain US state money transmitter laws.¹¹
  
• Any proposed stablecoin regulation is also likely to be considered in the context of overall efforts to unify and clarify the regulatory regimes that apply to crypto assets in general

¹ Marc Leong is also a co-author.

² See CoinMarketCap, Top Stablecoin Tokens by Market Capitalization, available at https://coinmarketcap.com/view/stablecoin/ (data retrieved May 13, 2022).

³ See Raynor de Best, Statista, Market capitalization of the 10 biggest stablecoins from January 17 to April 4, 2022, available at https://www.statista.com/statistics/1255835/stablecoin-market-capitalization/.

⁴ See Raynor de Best, Statista, TVL (total value locked) across multiple Decentralized Finance (DeFi) blockchains from November 2018 to March 30, 2022, available at https://www.statista.com/statistics/1272181/defi-tvl-in-multiple-blockchains/.

⁵ See Paul Kiernan, WALL STREET JOURNAL, Yellen Renews Call for Stablecoin Regulation After TerraUSD Stumble (May 10 2022), available at https://www.wsj.com/articles/yellen-renews-call-for-stablecoin-regulation-after-terrausd-stumble-11652208165.

⁶ Data retrieved from CoinDesk, available at https://www.coindesk.com/price/luna/ (last accessed May 17, 2022).

⁷ See REUTERS, G7 countries urge swift regulation of crypto assets - draft (May 19 2022), available at https://www.reuters.com/technology/g7-countries-urge-swift-regulation-crypto-assets-draft-2022-05-19/ (“The world's top financial leaders called on Thursday for the swift and comprehensive regulation of cryptocurrencies following turmoil that has seen the demise of the Terra stablecoin last week, a draft communique showed on Thursday.”). See also Marc Jones & Katanga Johnson, REUTERS, U.S. SEC's Peirce Sees 'Movement' on Stablecoin Regulations (May 12 2022), available at https://www.reuters.com/business/finance/secs-hester-sees-movement-us-stablecoin-regulations-2022-05-12/.

⁸ President’s Working Group on Financial Markets, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency, Report on Stablecoins (November 2021), available at https://home.treasury.gov/system/files/136/StableCoinReport_Nov1_508.pdf. Please also see our Legal Update on this issue: https://www.mayerbrown.com/en/perspectives-events/publications/2021/11/us-financial-regulators-release-muchanticipated-report-on-stablecoins.

⁹ The White House, Executive Order on Ensuring Responsible Development of Digital Assets (March 9, 2022), available at https://www.whitehouse.gov/briefing-room/presidential-actions/2022/03/09/executive-order-on-ensuring-responsible-development-of-digital-assets/.

¹⁰ Please see also our Legal Update on this proposal: https://www.mayerbrown.com/en/perspectives-events/publications/2022/04/senator-toomey-releases-stablecoin-regulation-legislation.

¹¹ See Circle, Is Circle regulated?, available at https://support.circle.com/hc/en-us/articles/212059046--Is-Circle-regulated (last accessed May 18, 2021) and Circle, Legal & Privacy — Licenses, available at https://www.circle.com/en/legal/licenses (last accessed May 18, 2021).