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How Stablecoins Destabilize Crypto – Crypto News Australia

This is a guest post by Robert McCauley, Non-Resident Senior Fellow at Global Development Policy and Associate Member of the History Department at Oxford University.

The fate of stablecoins is fateful for the entire crypto complex. This is not because of their size, but because of the essential liquidity role they play.

To refine the technical and legal difficulties involved in transactions between crypto and real dollars, the crypto market has developed its own near-dollars. These serve as vehicle currencies in crypto trading and provide crucial liquidity and collateral services. The major cryptocurrencies, bitcoin and ether, are bound to be worth a lot less in a trading environment with disrupted stablecoins. With the largest stablecoin fighting for its life, it’s not too early to step back and consider what’s at stake.

From euphoria to distress. . .

At its peak valuation of $3 trillion in early November, cryptomania enjoyed euphoria to the moon. Operating in a significant part of a legal no man’s land, the mania offered more incentive than most market participants to invent their own money and set up their own credit and leverage structures.

The crypto universe has made the transition from euphoria to distress in the months since prices peaked. Distress is also known as the Wile E. Coyote moment, when the cartoon character has run over the side of the cliff and, according to Warner Brothers physics, doesn’t fall until he’s looking down. Distress is characterized by those with more insight moving on to getting their hands on real money.

The cash movement of non-HODL (“hold on for dear life”) crypto holders has helped push crypto prices down. However, stablecoins not only held their price, but also continued to grow in their overall size. As of October 2021, they weighed $127 billion, over half of which was accounted for by the market leader Tether.

Stablecoins reached a total measured value of USD 180 billion at the end of February. It stayed at this level until May. Looking back, it’s odd how Wile E. Coyote-style stablecoins have continued. Hardship hit stablecoins belatedly last week.

Although there are multiple stablecoins here, the top four, Tether (USDT), USDC, BUSD, and Terra (UST), account for 90 percent of the market. Their percentages are 46, 24, 10, and 10, respectively.

What is the order of play? In 1992, testing of the exchange rate mechanism shifted from small and peripheral to central. First the Finnish mark was shot, then the lira and the pound were attacked, and finally the French franc. Likewise, the first stablecoin in sight was in the periphery.

Terra had three criticisms: size, algorithmic construction, and high interest rates. In terms of size, UST’s growth has just surpassed BUSD in the last month.

Many readers are by now familiar with the difference between an algorithmic and a supported stablecoin, although the difference is still worth defining. The latter is (or claims to be) an unregulated money market fund. Its pseudo-dollars are backed by such things as cash: bank deposits, Treasury bills, and commercial paper. Long stretches of stable outstanding balances raise questions about how Tether’s price has been stabilized: was this through (legally deferrable) redemptions by Tether, market operations by its operators, or stabilizing speculation by others?

Terra, an algorithmic stablecoin, claimed superiority as it has no such footing in traditional finance. Finally, a government can confiscate such assets or make it difficult for traders to buy and sell them. Stable Terra derives its stability from pre-programmed trading on a floating token, Luna. If Terra falls below face value, a merchant can buy it at a discount and use it at face value to buy a dollar’s worth of Luna, regardless of the Luna’s price. After the sale of the Luna, the retailer collects the discount.

But support for Terra’s face value depended on operations that expanded Luna’s supply, so fluctuating demand caused prices to swing lower, turning safe arbitrage into a loss.

Interest in UST was the third strike. The Terra Luna setup included the Anchor protocol (why not Acme, the mail-order source for Wile E Coyote’s clever devices?) paying 19 percent APY. And whenever you hear someone talk about a 19 percent yield on an asset that promises stable value against the dollar, put your hand on your wallet.

Not only was this rate obviously unsustainable, but it also drew the most outstanding UST to a visible place. Anchor had UST14 billion in deposits on Friday (out of $18 billion outstanding) but only UST9 billion on Monday and UST2.6 billion at pixel time. The transparency of the deposit amount can only help if coordination between the depositors is required. Big selling on the exchanges caused UST’s price to drop below face value, signaling that the bots were pumping out Luna.

An analogy is a fine piece of financial engineering from the 1980s: par-reset junk bonds, which were part of KKR’s 1989 acquisition of RJR Nabisco. The coupon on these bonds should be reset periodically to bring the securities up to face value. Once RJR Nabisco’s finances took a hit, an interest rate that would bring the bonds to face value would bankrupt the company. Only KKR injected new equity into the deal and kept the company’s finances from exploding.

The savvy, not-so-decentralized organizers of UST had already started preparing their creation for their test, buying bitcoin to back it. So far, the suggestion that they could sell some of their reported $3.5 billion in bitcoin holdings

. . . panic and crash?

It was fair to point out, as some did earlier this week, that secured stablecoins are different. Undoubtedly, they are not as unstable as algorithmic stablecoins. Still, 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 drive this process forward.

It’s not that USDT is unregulated. In 2008, the Primary Reserve Fund proved that SEC regulation was not proof that a money market fund was breaking the buck. And March 2020 showed that runs can also hit money market funds without breaking the buck. If stablecoins were going to 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 from red flags”. That work week Last October’s cover story needs to be read again: A leading, brilliant, shrill fire, but the crowded theater crowd stayed in their seats. Outrage greeted Tether’s first pie chart of its holdings, released last May.

Assumptions about the debtors and the nature of the trading paper holdings reported by Tether vary. Are these papers issued by distressed Chinese real estate developers? IOUs backed by cryptocurrencies? (How could these margin calls play out?) Or worse? The mélange could make Lehman Brothers trading paper, which broke the buck on the Primary Reserve Fund in September 2008, look pretty solid. When we witness the last minute panicthe strange thing is how long it took.

The stablecoin crypto vehicle

It may seem that stablecoins are a sideshow. Their market cap was less than 3 percent of the crypto market at the end of October 2021. The proportion has since increased, but still not by much.

Nevertheless, the trading and thus the liquidity of the crypto market depends on stablecoins. In particular, decentralized financing runs on stablecoins. Tether’s market cap of over $80 billion is now about a tenth the combined market cap of Bitcoin and Ether, but the measured daily trading volume is higher than their combined turnover.

Bitcoin pricing occurs in derivatives trading, where Tether serves as the margin and settlement currency. What trading the dollar against the euro is to currencies, trading bitcoin against tether is to crypto. On the Binance exchange, the pricing of reassuringly named perpetual swap contracts involving bitcoin and tether is driving bitcoin prices in US dollars and affecting prices across crypto more broadly.

Without Tether, or at least without stablecoins, it is not clear how the crypto complex works. Vehicle currency issues would affect the liquidity of the entire crypto complex, just as the “dollar shortage” in late 2008 affected the liquidity of the entire forex market. Less liquid assets are worth less. And if a prominent stablecoin essentially becomes a worthless entry in nobody’s spreadsheet, it would indicate that other cryptos could go to zero.

Source: Crypto News Austria

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