War on Terra: The nets will approach the key components of the cryptosystem

TerraUSD is a completely different beast. It is an algorithmic stablecoin that relies on financial engineering to achieve its peg with the US dollar. Obviously, the algorithm was discovered under pressure last week.

In simple terms, TerraUSD relied on arbitrage with its sister currency, Luna, to maintain its one-to-one peg with the US dollar. The coins are redeemable, where $US1 from Terra would always be worth $US1 from Luna.

Terra founder Do Kwon is desperately trying to find a way to keep the Terra blockchain and ecosystem running.Credit:Bloomberg

If TerraUSD trades above $US1, there is an incentive for traders to buy Luna and exchange it for TerraUSD, yielding a profit. Likewise, if TerraUSD trades below $US1, traders have an incentive to buy them and trade them for $US1 from Luna.

In theory, that should ensure that TerraUSD, while a purely virtual construct with no physical resources to back it up, would always be worth $US1.

In practice, when investors lost confidence last week it ignited a self-sufficient spiral to near oblivion for both.

Less than a month ago, Luna had a market cap of over $30 billion ($42.9 billion) and the TerraUSD market was valued at over $18 billion. Today Luna is essentially worthless and Terra is valued at less than $2 billion.

It is the magnitude of the meltdown and the key role stablecoins play in the broader crypto market that leaves regulators uncertain. The coins are a conduit between the conventional financial system and the crypto universe. Within the crypto asset market, they provide the currency and an efficient and supposedly secure mechanism to facilitate transactions.

The sooner there is appropriate regulation, the better – both for crypto investors and for the future stability of financial systems.

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

The structure of the more conventional stablecoins like Tether, with billions of dollars in conventional assets, and the potential of “DeFi” to generate massive efficiencies and consumer benefit explains the tensions in the debate over whether to regulate them.


It is a more focused discussion than the broader issue of whether crypto assets should be regulated in general, because the potential threats and benefits that stablecoins and their role in supporting DeFi can generate are of much greater systemic impact, or that in anyway could be.

Janet Yellen, who has called for regulation of stablecoins in the past, told a congressional hearing late last week that she would not characterize Tether’s “breaking the buck” as a real threat to financial stability, but added that stablecoins grow (or were growing) very quickly.

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

In the US, the Treasury Department and the Federal Reserve Board and other financial sector regulators want to be able to regulate stablecoin issuers in the same way they regulate traditional financial institutions, imposing capital and liquidity requirements, along with much greater disclosure and ongoing oversight.

That would reflect the view that stablecoins could eventually pose a threat not just to consumers, but to the system if they grow so large as to create a run similar to the one that wiped out TerraUSD and temporarily destabilized Tether. forced to dump assets to meet repayments.

Investors panicked when the stablecoins lost their peg to the US dollar.

Investors panicked when the stablecoins lost their peg to the US dollar.Credit:Phil Carrick

Ultimately, it is likely that there will be a range of different regulations and regulators imposing banking-like and some securities industry-style regulations on different types of crypto assets to account for their different risk profiles.

The lack of transparency in cryptos makes it impossible to understand if there is anything beyond a broad correlation between what is happening in crypto markets and developments in traditional securities markets.

The extent to which traditional financial institutions such as banks, investment banks, hedge funds and high net worth individuals have become involved in the crypto market – they now account for something close to, if not more than half of the activity – suggests the potential for spillovers.


If a Tether or a TerraUSD is akin to a money market fund, then if the stablecoin sector in particular grew large enough, a crisis of confidence and a run on a crypto asset could export liquidity problems to the conventional financial system.

The sooner there is appropriate regulation, the better – both for crypto investors and for the future stability of financial systems.

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