War on Terra: The nets are set to close in on key parts of crypto system

The TeraUSD is a very different beast. It is an algorithmic stablecoin that relies on financial engineering to achieve the peg with the US dollar. Clearly the algorithm was found under pressure last week.

In simple terms, the teraUSD relied on an arbitrage with its sister coin, the Luna, to maintain its one-to-one peg with the US dollar. The coins are interchangeable, with $US1 of Terra always considered worth $US1 of Luna.

Terra founder Do Kwon is desperately trying to work out a way to keep the Terra blockchain and ecosystem running.Credit:bloomberg

If TeraUSD trades above US1 there is an incentive for traders to buy Luna and exchange it for TeraUSD, thereby reducing profits. Similarly, if TeraUSD trades below US1, traders have an incentive to buy them and swap them for US1 of Luna.

In theory, this should ensure that TerraUSD, while a purely virtual creation with no physical assets to back it, will always be worth US1.

In practice, once investors lost confidence last week, it ignited a self-fueled spiral for both of them almost into oblivion.

Less than a month ago, Luna had a market capitalization of over US30 billion ($42.9 billion) and the TerraUSD market value exceeded US$18 billion. Today Luna is essentially useless and Terra is worth less than US$2 billion.

It is the magnitude of the recession and the crucial role stablecoins play in the broader crypto market that has destabilized regulators. Coins provide a conduit between the traditional financial system and the crypto universe. They provide currency and an efficient and secure mechanism to facilitate transactions within the market for crypto assets.

The sooner there is proper regulation for crypto investors, the better for the future stability of financial systems.

They are considered central to smart contract-enabled applications using blockchain technology as the brave new and potentially (for traditional finance) intended to replace the frontier of decentralized finance and replicate and displace traditional financial services.

The structure of more traditional stablecoins such as Tether, which holds traditional assets worth billions of dollars, and the ability of “DeFi” to generate massive efficiency and consumer benefits explain the tension in the debate about whether or not to regulate them.

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This is a more focused discussion than the broader issue of whether crypto assets should be regulated generally because the potential dangers and benefits that can pose to stablecoins and their role in backing DeFi have far more systemic consequences, Or at least there can be.

Janet Yellen, who has called for stablecoins to be regulated in the past, said at a congressional hearing late last week that she would not characterize Tether’s “breaking the buck” as a real threat to financial stability. But he said that stablecoins are rising (or were rising) too fast.

Yellen called on lawmakers to legislate for federal supervision of stablecoins by the end of this year. There is a similar push for immediate regulation in the UK and Europe.

In the US the Treasury Department and the Federal Reserve Board and other finance sector regulators want to be able to regulate stablecoin issuers in the same way they regulate traditional financial institutions, with the imposition of capital and liquidity requirements— Along with far more disclosure and ongoing supervision.

This would reflect the view that stablecoins could ultimately be a threat not only to consumers, but to the system if they become so large that a similar event would wipe out TeraUSD and momentarily destabilize Tether. The run had to evolve and issuers were forced to dump assets to meet redemptions.

Investors panic when stablecoins lose their peg against the US dollar.

Investors panic when stablecoins lose their peg against the US dollar.Credit:Phil Carrick

Ultimately it is likely that there will be different regulation and regulators enforcing some bank-like regulation on different types of crypto assets and some securities industry style regulation to account for their different risk profiles.

The lack of transparency in crypto makes it impossible to understand whether there is anything beyond the broad relationship between what happens in crypto markets and developments in traditional securities markets.

The degree to which traditional financial institutions such as banks, investment banks, hedge funds and wealthy individuals have joined the crypto market – they now account for some, if not more than half of the activity – suggests the potential for spillover effects. .

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If Tether or TeraUSD is similar to money market funds, there could be a crisis of trust and a run on crypto assets, especially if the stablecoin sector is to grow sufficiently, exporting liquidity issues in the traditional financial system. Do it.

The sooner there is proper regulation for crypto investors, the better for the future stability of financial systems.

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