Stablecoins – Is this time really different?

Unless you have been locked down in Shanghai, you probably know about the collapse of the Terra Luna (LUNA) cryptocurrency and the USD Terra (UST) stablecoin in the past week. While these cryptocurrencies are not the first to blow up or fail, they are certainly the largest and most spectacular so far! And part of the reason that this collapse is so spectacular is because UST is a stablecoin, pegged at a value of US$1, and used to facilitate other cryptocurrency transactions as well as other decentralised finance (DeFi) operations like lending, borrowing and liquidity staking. The recent events and the reasons for them are reported elsewhere, but what is of greater interest is the promise of DeFi and stablecoins, and whether this time is really different from other currency crisis episodes in traditional finance (TradFi) history.

To infinity and beyond!

What are Stablecoins in the Cryptocurrency menagerie?

The original cryptocurrency, Bitcoin (BTC), has been around for more than a decade. Back then, proponents of cryptocurrency argued that a decentralised, trustless currency based on the blockchain was the solution to what they seen was rampant money creation by centralised institutions like central banks. Of course, this appears to be wrong on every single count:

Money is created (and destroyed) by decentralised banks. Central bank money creation takes place mainly to offset the fall in money supply due to money destruction by these very same decentralised banks.

To qualify as a currency, cryptocurrency needs to be a medium of exchange, a unit of account and a store of value. None of these are fulfilled by the blockchain technology as the speed of transactions and the volumes transacted cannot come close to what traditional finance payments systems operate at. The volatility of the value of cryptocurrencies also makes them a poor store of value. And hence, they are not used as a unit of account, since you cannot set prices for goods and services in cryptocurrency without needed to revise them in microseconds as their value changes.

But the creation of stablecoins a few years back was supposed to change that. Stablecoins, such as Tether USD (USDT), USD Coin (USDC), Dai (DAI), Binance USD (BUSD) and Terra USD (UST) were designed to maintain a value of US$1 at all times (well, most of the time), and this would serve as “money” in the cryptocurrency world, since they can be used as a medium of exchange, a unit of account and a store of value, much like the US Dollar (USD) would in the real world. Is this time really different? Did stablecoins help bring cryptocurrencies closer to what money is in the real world?

What has happened though, is that stablecoins have been successful in facilitating transactions in buying and selling other volatile cryptocurrencies. As interest in cryptocurrencies grew, exchanges sprang up to facilitate trading. Since the blockchain (which is based on the slower proof-of-work mechanism for many popular cryptocurrencies) can only handle that many transactions between cryptocurrencies and actual real-world currencies per unit of time, the use of stablecoins allowed transactions to be done off the blockchain, through the transactions of cryptocurrencies for stablecoins.

So in the world of cryptocurrencies, stablecoins have become like money. Perhaps this time is really different for these stablecoins. But just like in the real world, where currency transactions against the USD are largely for speculation and only a small portion is actually for trade of goods and services, so too, in the cryptocurrency world, most of the transactions against stablecoins are really for speculation! If that was the true purpose of cryptocurrencies, then you can say the originators have succeeded! After all:

Imitation is the sincerest form of flattery that mediocrity can pay to greatness.
– Oscar Wilde

The curious case of Terra Luna

As we mention, you can find out about the collapse of UST and LUNA here and here.

Just for completeness sake, stablecoins in the realm of cryptocurrencies fall into three main categories:

Collateralised by real world assets. For example USDC has cash and US Government securities backing it, while USDT has investment grade commercial paper backing it
Collateralised by cryptocurrencies. For example, we create DAI when an amount of Etherum (ETH) over and above the same amount of DAI backs it as collateral
Algorithmic stablecoins, like UST, have an arbitrage function built in to help maintain the value of the stablecoin

Specifically for UST, the pegging mechanism allows users to “burn” 1 UST in exchange for US$1 of LUNA, and vice versa. Suppose UST falls below US$1, say to US$0.99. Arbitrageurs can buy 1 UST for US$0.99, and burn it to get US$1 worth of LUNA. The reduction in the supply of UST then pushes its value back towards US$1, assuming demand for UST remains unchanged. These arbitrageurs can then earn US0.01 profit per UST by carrying this out. In a market where the price of LUNA has been going up, this would be a good deal!

In the opposite case, suppose UST goes above US$1, say to US$1.01. Arbitrageurs can “burn” US$1 worth of LUNA to get 1 UST, and sell it for a US$0.01 profit. The expansion of supply of UST will then push it back towards US$1, ceteris paribus. Clever, right? But this is where the naiveté of the designers (or perhaps of the investors) of UST shows up. Just because the design of UST works this way, doesn’t mean that it will always work this way. When something gets financialised, you can be sure that there are many clever people with deep pockets trying to do things differently from the plan, to see whether they can profit from it.

As noted above, the arbitrage at the heart of the algorithmic stablecoin like UST only works if the deviations from the peg are small, and there are no changes in the demand of UST. But what if the deviations are large, like 10% or 20%? Would the potential arbitrageurs still want to remain in the Terra-Luna (UST-LUNA) ecosystem? Or would they bail out and sell everything as fast as they can? Or to think of it another way, in the past, if Sembcorp Marine shares are in freefall, would you want to hold Sembcorp shares?

And we all know what happened next. For the UST stablecoins, this time was no different from the past, just like TradFi. This is why we can’t have nice things. Or why we can’t have nice things when we try to make a profit from it. Because there is someone else on the other side trying to make a profit from it at your expense!

The fall of UST

We have been here before – The parallels with Free Banking

Now, although we have spilt quite a bit of (digital) ink talking about UST, believe it or not, that is not the purpose of this blogpost! No, really! What piques our interest in this is that the entire DeFi project of creating a decentralised currency free from the influence of any central authority (the dream of libertarians!) is nothing new! In fact, it closely parallels events from almost 200 years ago. Like they say, there is nothing new under the sun!

The period between 1837 to 1862 is the Free Banking era in US financial history. You can read more about free banking here. But in a nutshell, the US Congress failed in its attempt to set up a national bank (i.e. a bank which can operate in every state in the USA), and in its place, state licensed banks were allowed to set up, and issue their own banknotes! This sounds a lot like like what the people behind USDT, USDC, BUSD, DAI and UST are trying to do, issue their own currency, which is pegged to a fixed value. And which can in theory be accepted and used by anyone for transactions.

Of course, back then it was not free-for-all, as it is in cryptocurrencies right now. These free banks still had to adhere to minimum reserves required of them. This meant backing each banknote issued with state government securities. But after that, they were free to create more money by lending out these banknotes, then taking them as deposits, and lending them out again. This is what decentralised money creation looks like. And this looks an awful lot like what stablecoins, and yield and liquidity staking look like today as well!

In the end, what happened was that wild cat banks (i.e. banks set up and failing within a year) proliferated. There was even a Bank of Singapore in the USA back then! Traders looked at each bank and tried to assess the assets backing the banknotes issued. There were thick guides which gave the exchange value of each banknote for another. For example, because of poorer assets backing them, banknotes from Bank A amounting to $100 may only be exchangeable for $95 worth of banknotes from Bank B.

The original Bank of Singapore in the state of Michigan, USA

But what really distinguished the free banks (and their banknotes) which failed, and those which did not, was ultimately the quality of the assets backing the banknotes, explained here. To elaborate, all free banks had to put up reserves in the form of state government securities. But not all state governments had equally sound finances. In fact, many of them tottered on the verge of bankruptcy most of the time. While a bank could have $100 of securities as reserves, these securities may be worth only $85. So the $100 of banknotes have only $85 of assets backing them.

This sounds suspiciously similar to the stablecoins in the cryptocurrency world today. One unit of DAI is $1.50 worth of ETH backing it today, but what if ETH falls by 40% tomorrow? One unit of USDT has $1 in face value or nominal value of commercial paper backing it, but what if the commercial paper is trading at 95 cents to the dollar now?

The free banking era ended with the creation of the Office of Controller of Currency to issue banknotes. Note that this did not fully solve the problems of monetary and financial instability in the USA because the Federal Reserve System did not exist yet (1913), nor did the Federal Deposit Insurance Corporation (1933). So while it is always sexy to talk of creating an independent decentralised monetary system through cryptocurrencies and DeFi, TradFi has been there before, long ago. And TradeFi has survived all these years, just barely at times, by creating the institutions and mechanisms to counter the instability, the attacks and schemes in the financial system brought on by the financialisation of the economy and monetary system.

So are stablecoins really different this time? At the end of the day (this week):

TradFi 1 : DeFi 0

Reflexive Markets

Just because there is a chance of failure for cryptocurrencies doesn’t mean that they will immediately crash. Even if a stablecoin has a 30% chance of failure, it can survive a very long time (although not indefinitely) based on the 70% chance of survival. And even with financialisation, with the hungry horde of bankers and hedge fund managers formed up in their legions to profit from the fall of cryptocurrencies and stablecoins, there is no guarantee that every attack will be successful.

Why then did UST collapse under its own weight? The answer may lie in the writings of George Soros. Yes, the Soros who broke the Bank of England and the Pound Sterling back in 1992. Who may know a bit more about speculative attacks and opportunities than virtually anyone involved in cryptocurrencies today. As outlined in his book The Alchemy of Finance (written before the attack on the Pound Sterling), Soros believes that markets are reflexive, as opposed to efficient. What it means is that the market can be influenced by your actions, and the course of events can change in response.

In the context of UST (and many real world currencies like the Thai Baht, Malaysian Ringgit, Indonesia Rupiah, Mexican Peso, to name a few), even where reserves are in place and supposedly fail safe defensive mechanisms and algorithms prepared, a well placed and publicised attack can raise the chance of a failure from 0.5% to 10% very quickly if other market participants respond in kind, in a reflexive manner. Of course, it can go wrong too. If the other participants trade against you instead, the chance can just as quickly go from 10% to 0.5%. And ultimately, that seems to be what happened in the case of UST. A small deviation from the peg turned into a torrent as other speculators decided to abandon the ecosystem. It does not need a coordinated attack, just a reflexive response.

If only the creators of cryptocurrencies and stablecoins spend a little more time learning financial history, as well as market psychology, they can design a better system than those existing today. Then maybe, just maybe, for stablecoins and cryptocurrencies, this time may really be different!