HomeInsightsAre stablecoins stable, and how might the recent de-pegging of UST affect the UK’s plans for a stablecoin regulatory framework?

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This week, one of the world’s most popular distributed ledger projects suffered a major run of money exiting its platform. Anchor, which is a borrowing and lending protocol with purportedly fixed yields built on top of the Terra blockchain, was also one of the most ambitious DeFi projects seeking to provide stability in what is known to be a volatile market.

In the last few days, $5bn of a total $14bn in deposits have been withdrawn from the Anchor ecosystem. Anchor had previously offered yields of up to 19.5% by harnessing the power of multiple proof-of-stake blockchains, allowing token holders to stake their tokens in exchange for a form of interest payment in cryptocurrency. A core aspect of the financial system built around Anchor is its stablecoin, TerraUSD (UST) (one of the world’s largest algorithmic stablecoins by market cap). UST was designed to be a stable cryptoasset, whose price would remain pegged to the value of the US dollar. Over the last few days, reports of repeated divergence between UST and USD have called this into question, and the ramifications for an increasingly scrutinised corner of the crypto industry are discussed below.

A stablecoin (sometimes called an ‘asset-referenced token’) is a cryptoasset whose value is ‘pegged’ to the value of a more stable asset (ie. it tracks a stable value in some way). Stablecoins were created in response to the high volatility of cryptocurrency. Most cryptocurrencies, by contrast, are valued by the market, ie. by the price traders and other market participants are willing to buy and sell them for.

Technically speaking, a stablecoin’s value is determined in the same way, but there are two prevalent ways in which their design aims to prevent speculation from altering their price:

  1. An asset-backed stablecoin keeps reserves of the asset to which it is pegged. This could be an established fiat currency or commodity price. For example, BUSD is a stablecoin that can be redeemed for USD from its issuer (Paxos), who keep reserves of USD equalling the total supply of the stablecoin. Therefore, there is no incentive for the price to drift above or below 1 USD – ie. there can be no meaningful speculation.
  2. An algorithmic stablecoin is still pegged to a more stable asset, again usually a fiat currency, but instead of holding reserves of such asset, algorithmic approaches are used to stop the price from drifting (or “de-pegging”), such as the UST algorithm described below.

The Terra blockchain was largely created to facilitate the creation of stablecoins. Anchor’s UST is one of more than 140 projects built on Terra, and operates as follows:

UST can be redeemed for LUNA, the native token of the Terra blockchain. 1 UST can be redeemed for $1 worth of LUNA. This means that if the price of UST were to fall to, say, $0.99, arbitrageurs (traders who seek to profit from market inefficiencies) will quickly convert UST to LUNA (or vice versa if the price drifts to, say, $1.01), and make a fast $0.01 on the difference.

An inbuilt token ‘burning’ mechanism means that when you convert LUNA to UST, you are effectively minting new UST while the equivalent LUNA tokens are destroyed – and vice versa for converting UST to LUNA. This burning mechanism, together with the increased demand which a (momentary) fluctuation in a stablecoin can cause, theoretically pulls the price back to its pegging using the power of supply and demand.

Some jurisdictions make a distinction between the approaches to stabilisation above.

In the UK, Cryptoassets are not generally considered to give rise to a stored monetary value, which means they are unlikely to be considered e-money since e-money is effectively pre-paid spending power. Cryptocurrencies like Bitcoin also don’t give a right of redemption against their issuer. However, some asset-backed stablecoins, including BUSD as mentioned above, do give such a right – ie. the right to redeem the token for USD held in reserve.  There is therefore a potential for such stablecoins to be characterised as e-money.

Algorithmic stablecoins, by contrast, do not give redemption rights for fiat or any asset.  The FCA has drawn out this distinction (as well as another category of stablecoins backed by a non-fiat asset such as gold). This distinction is also made by the EU’s proposed MiCA regulation, which refers to asset-referenced tokens and e-money tokens as distinct asset categories.

In our previous article, we highlighted the UK’s intention to bring stablecoins within its existing regulations on electronic payments. This stems from an understanding that stabilising forces are vital to a prosperous crypto industry and that, since they can offer a store of value, stablecoins are more likely to be used in place of money than volatile, speculative cryptocurrencies.

Cryptoasset service providers and their suppliers will need to carry out a full analysis of the relevant stablecoin, its backing, and its algorithmic mechanisms, in order to understand its regulatory status.

This week, UST de-pegged from the US dollar. Because there is no single issuer against whom a token holder has a right of redemption, algorithmic stablecoins to some extent rely on balanced market forces.

When the market loses confidence in the stability of the stablecoin, the price can quickly spiral. Recent speculation around the sustainability of the lending yield pay-outs on the Anchor protocol (which is essentially a decentralised money market where UST holders can earn huge returns for staking their tokens on the platform, paid out from so-called yield reserves), as well as the recent fall in value of most cryptocurrencies triggering margin calls for traders, may have fed into the uncertainty in this case. The knock-on effects have been significant, with billions of dollars exiting the platform and a sharp fall in the value of associated tokens, such as the Anchor governance token.

There is concern among some that the volatility of crypto markets represents a systemic risk to the world’s financial systems. There has also been controversy around previous stablecoin projects, with concerns around ensuring that the issuer of a fiat-backed stablecoin actually has the reserves it claims (see Tether’s fine in 2021 by the US regulators).

However, with stablecoins under increased scrutiny, and the UK looking to create a framework for their regulation and supervision, there is likely to be further discussion around how algorithmic stablecoins are described. The distinction between asset-backed and algorithmic stablecoins is set out at a high level above, but in reality stablecoin projects are technically complex and nuanced with innovative approaches springing up frequently. There is a concerning lack of clarity around:

  • describing an asset as “pegged” to a stable asset when it can become de-pegged at short notice by the market
  • publicising “reserves” which are actually made up of another cryptoasset
  • describing an asset as stable to retail investors when it may well not be
  • the technical resilience of algorithms purportedly maintaining the stablecoins’ pegs, as well as the average person’s ability to understand their mechanics, and
  • the level of disclosure required around how an algorithm may fail to maintain a stablecoin’s peg

We continue to watch the FCA and UK government’s approach in this area with interest.