If you ever brave the cryptoverse or find occasion to go spelunking in the “decentralized web” (as MetaMask euphemistically describes a giant, unregulated casino), you’ll find yourself dealing in stablecoins pretty much immediately.
To the extent the general public knows anything about stablecoins, laypeople tend to think in terms of blockchain tokens pegged to the dollar and backed by USD assets, like short-dated US government paper. Circle’s USD Coin (USDC), for example, is fully-backed and always redeemable 1:1 for US dollars. Circle publishes monthly attestation reports by Grant Thornton.
Even “regular,” fully-reserved stablecoins are the subject of vociferous debate. They’re a hot topic on Capitol Hill, and the discussion is at the forefront of the crypto regulation push.
But stablecoins come in all flavors, from vanilla to tropical fruit, and can be used for all manner of purposes, from the pedestrian to the exotic. Let’s say you flip a blue chip NFT for a tidy profit but don’t want to pay taxes on it just yet. You might convert your Ethereum proceeds to USDC and leave the balance sitting in your on-chain wallet, rather than transferring the funds back to a centralized exchange, where they’d be visible to the prying eyes of zealous tax authorities.
But you might do other things, too. Like participate in a liquidity pool using a stablecoin pair in order to minimize impermanent loss. And maybe that involves holding an algorithmic stablecoin, which depends on automation, arbitrage, active management of treasury assets and incentives to maintain a peg. Hold that thought.
One of the most popular algorithmic stablecoins, TerraUSD, broke the proverbial buck over the weekend causing extreme consternation and compelling its backers to intervene. On Monday, the situation unraveled completely (figure below).
I won’t pretend to know how accurate Bloomberg’s retelling actually is, but I will briefly quote their summary of what happened over the weekend, because it speaks to the point made above about liquidity pools. “The de-pegging was likely triggered by withdrawals of TerraUSD on decentralized projects Curve Finance and Anchor, according to blockchain data and crypto market participants,” Muyao Shen wrote, adding that “Terraform Labs initially removed $150 million TerraUSD from Curve to prepare for a new liquidity pool going live this week and sent back $100 million TerraUSD after the TerraUSD depeg.”
There’s (much) more to the story than that, but the point is just to underscore the fact that stablecoins are more than volatility shelters for blockchain inhabitants seeking to temporarily shield funds from wild swings. Curve, which I’ve used personally, is well-known to any DeFi participant. The so-called “Curve Wars” have spawned a number of offshoot protocols including Convex, where users can participate in Curve’s pools vicariously while earning additional rewards on a more user-friendly interface. Convex was part of my multi-month experiment in Web3 documented extensively here in late March.
Exactly none of this is regulated by anyone, anywhere, and as Bloomberg went on to gently note, “there are around 18.5 billion of TerraUSD in circulation… a big enough presence that its swings could have systemic implications for other coins and protocols.”
The worst of the plunge illustrated in the figure (above) coincided with a quick leg lower in Bitcoin to below $30,000 on Monday evening in the US. I was having dinner on the back deck, but as luck would have it, I saw it unfolding and enshrined the moment in a quick tweet (below). Luna, Terra’s native token, is an integral part of the arbitrage process.
wow. LUNA just collapsed.
— Heisenberg Report (@heisenbergrpt) May 10, 2022
I should note that Bloomberg’s characterization of TerraUSD as “the most controversial of these kinds of tokens” may not be accurate, or at least not if “these kinds of tokens” refers to all algorithmic stablecoins. A few months ago, for instance, I was several thousand dollars into something called Tomb, a seigniorage-based algorithmic token pegged not to the dollar, but to Fantom, a Halloween-themed cryptocurrency that lived (and, ultimately, crashed) by its association to a well-known DeFi developer named Andre Cronje.
In any case, the specifics of this are largely irrelevant for wider audiences. The point is to emphasize i) the risks posed by self-referential DeFi dynamics which, in my opinion, are material, underappreciated and not well understood, and relatedly, ii) the potential for DeFi mishaps to spill over into more traditional markets.
On May 1, I warned on potential DeFi de-leveraging amid the broader risk-off move catalyzed by rising US real rates. If crypto is a hedge against free money, note that money stopped being free recently as developed market central banks began hiking rates in tandem.
In a Tuesday note, Nomura’s Charlie McElligott alluded to “shadow leverage” in crypto. “I found it quite notable that purported stablecoins broke the buck ahead of Monday’s [market] meltdown, on what would reasonably seem to be ‘runs’ that forced liquidations in their underlying assets,” he said. For some, those assets may be “just a ‘cash’ wrapper claim” if they “instead include holdings of other ‘corr 1’ crypto that had to be sold into the de-leveraging spiral.”