By Brad Yasar, Founder and CEO of EQIFi
Terra’s dramatic meltdown has sent ripples across the blockchain space, bringing its total market cap down by billions of dollars. The crisis was not lost on the powers that be, with G-7 finance ministers said to be pushing the pedal to the metal on crypto regulation. While the matter is indeed urgent, if not long overdue, regulators must acknowledge the nuance inherent in the crypto space, which is diverse and bustling. And as a matter of fact, Terra’s downfall actually could come in handy to this end, as it sheds new light on one of the crypto sectors where this nuance makes all the difference.
The stable(?)coin problem
One of the main tokens in the Terra ecosystem was the $UST—an algorithmic stablecoin that used to be one of the top tokens by market capitalization, albeit not as big as Tether. The coin was supposed to trade 1:1 against the U.S. dollar thanks to an arbitrage-based mechanism linking it with another token, $LUNA, now known as Luna Classic ($LUNC). Users could burn $1 worth of $LUNA to mint one $UST, so arbitrage traders could swoop in to correct the rate whenever the $UST traded above or below $1. However, a large selloff threw the mechanism off-balance, sending the ecosystem on a downward spiral that brought us where we are right now.
As the name implies, a stablecoin must be stable, i.e. trade at a fixed rate against its peg. This allows such assets to function as a way for crypto traders and investors to solidify their gains on more volatile digital assets. In a bear market, which is what we have right now, stablecoins also offer investors a way to exit the down-spiraling assets and cut their losses while still keeping their capital on-chain.
Such stability doesn’t come out of thin air. When designing products, stablecoin projects can essentially select between one of the two overarching paths. The first option is to collateralize the coin, holding the actual peg assets in the amount corresponding to the coins’ circulation. The other option is to build an algorithmic mechanism that would mint and burn the coins to regulate their scarcity and, thus, value.
Terra’s $UST was one of the biggest experiments with algorithmic stablecoins—and it perfectly highlights the issue with such endeavors. As solid as the maths powering it may be, the mechanism enabling a billions-worth ecosystem to work as intended relies on non-intrinsic factors that developers cannot control. It takes the behavior of market actors for granted, effectively entrusting them with preserving the token’s stability, which goes against blockchain’s zero-trust tenets and is simply irresponsible.
Granted, Terra’s $UST is not the first algorithmic stablecoin to fail, not even as far as its own maker is concerned, it seems. Such a questionable track record for the entire sector could make it a target for a regulatory crackdown, especially given how non-conventional algorithmic stablecoins are from the standpoint of traditional finance. But this crackdown should not expand to the larger stablecoin industry, as not all stablecoins belong on the same shelf.
A more familiar instrument
A collateralized stablecoin maintains its peg in a more straightforward fashion. In the most basic terms, its issuer holds the target asset in custody in an amount that’s enough to cover the active circulation 1:1. So for a hypothetical stablecoin pegged to gold, the issuer would hold physical gold bullion for every token in circulation. Optionally, they would also offer all token holders an opportunity to trade their tokens for the appropriate number of gold bars, should they wish.
Of course, the reality is rarely as clear-cut, and collateralized stablecoins do have their own long-running reputational issues. Tether, the largest stablecoin by market cap, ended up in hot water as it turned out it held some of the collateral in short-term corporate debt, besides cash equivalents. Furthermore, $USDT token holders have a few hoops and loops to jump through if they want to redeem their tokens for fiat.
Still, Tether’s struggles point to the key areas that regulators should look at when developing the playbook for collateralized stablecoin projects. In financial terms, they are quite easy to see as securities, digital certificates standing in on-chain for off-chain assets. As such, third-party audits checking whether the issuer indeed holds the collateral in the declared amount should become a staple for the industry—and a crucial component of any regulations for the sector.
Another valid question is what assets a licensed and compliant stablecoin issuer should hold as the collateral. Hard cash is indeed the most liquid and secure option, as some officials assert, warding off the prospect of a bank run. That said, just as banks use deposited money to turn a profit, it may make sense to give stablecoin issuers some leeway for putting the cash in their custody to work while adhering to a specific minimum capital requirement.
The spectrum of activities that stablecoin minters can do with the funds to turn a profit is another valid regulatory vector, which again begs for a comparison with banks. Lending, for example, is a staple of the banking industry and a regulated activity. It seems only fair that stablecoin projects that lend the fiat cash at hand should fall under the same regulations.
While Terra’s collapse may prompt more regulatory vitriol against the stablecoin industry, governments must avoid a one-size-fits-all approach. The sector is more diverse than it may seem, and some of its participants are more aligned with traditional finance than others.
About the Author:
Brad Yasar, is the Founder and CEO of EQIFi, a leading regulated global DeFi services platform backed by EQIBank. Before EQIFi, Brad founded and co-founded a wide array of blockchain businesses, including Beyond Enterprises LLC, a leadership and technical support service for blockchain projects, and Blockchain Investors Consortium asset management organization, and HYVE, a decentralized platform for freelancers. Brad holds a Bachelor's degree in Economics and International Business Management from Pepperdine University, California.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.