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Risks of Stablecoins Highlighted as Terra’s Peg Breaks

James Albert by James Albert
May 12, 2022
in Special, Stablecoins
0

FintechZoom > World > Special > Risks of Stablecoins Highlighted as Terra’s Peg Breaks

Fitch Ratings-Hong Kong/London-12 May 2022: The failure of the algorithmic peg mechanism fixing the price of Terra’s USD stablecoin (UST) and the umooring of Tether from its USD peg highlight the fragile nature of private stablecoins, and will accelerate calls for regulation, says Fitch Ratings.

We have previously indicated that algorithmic stablecoins have struggled to win regulatory acceptance, as they can face particular risks in maintaining a stable value. In the case of UST, the backing entity’s crypto reserve was not sufficiently large to serve as a source of stability when the UST’s algorithmic peg mechanism came under speculative pressure. Over 10-12 May 2022, UST consistently traded at values well below USD1. The largest stablecoin, Tether (USDT), also diverged from USD1:USDT1, though more marginally.

Link to Infogram: Terra USD (UST) Value and Trading Volumes

We expect recent developments to lead to increased calls for regulation of stablecoins. The US Treasury Secretary, Janet Yellen, has already said it shows the importance of having an appropriate regulatory framework for stablecoins. The EU’s Markets in Crypto Assets regulation, nearing finalisation, will not permit the issuance of algorithmic stablecoins and requires bank-like regulation and reserves for systemic stablecoin issuers.

Stablecoins backed by reserve assets with clear fiat currency value face a fundamentally different set of credit issues to algorithmic stablecoins, in our view. In such cases, the stablecoin’s stability risks can be more manageable, depending on various factors, notably the safety and liquidity of the reserve assets. Other factors relevant to the credit profiles of the issuers of reserve-backed stablecoins include regulatory risk, counterparty risk (including reserve custodians), transparency over reserves and the extent to which the underlying assets are truly uncorrelated, the legal rights of stablecoin holders, and governance and operational risks.

Terra is one of the largest stablecoins, but its market value on 8 May before the pressure on its peg was only around USD18.6 billion, below that of larger stablecoins like Tether (USD83.2 billion) or USD Coin (USD48.7 billion). Investors will likely pay more scrutiny to the risks surrounding stablecoins and their reserve attestations given that UST’s problems have sparked wider crypto market volatility. It is unclear what impact this will have, but it could result in stablecoins with a lower risk profile gaining market share, or weaker investor appetite for stablecoins in aggregate.

There could be significant negative repercussions for cryptocurrencies and digital finance if investors lose confidence in stablecoins. The latter play an important role in catalysing the crypto ecosystem more broadly, by providing a stable link to fiat-currency financial markets.

The failure of Terra’s peg has sent shocks through the decentralised finance (defi) sector, with a key saving and lending protocol, Anchor, seeing massive liquidation of UST-collateralised loans and the pricing of other crypto tokens also being affected. This has led to further liquidation triggers throughout the ecosystem, for example on the AAVE protocol. Bouts of volatility will probably continue as the crypto sector digests the repercussions of the failure of the UST peg, and as US policy rate increases and equity volatility pressure high-beta assets.

Links between crypto markets and regulated financial markets remain weak. We expect this to limit the potential for crypto market volatility to spill over and cause wider financial instability. However, many regulated financial entities have have increased their exposure to cryptocurrencies, defi and other forms of digital finance in recent months, and some Fitch-rated issuers could be affected if crypto market volatility becomes severe. There is also a risk of an impact on the real economy, for example through negative wealth effects if crypto asset values fall steeply. Nonetheless, we view the risks to Fitch-rated issuers and real economic activity as being generally very low.

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James Albert

James Albert

James Albert is a personal-finance analyst for FintechZoom and is based in New York. Contact: [email protected]

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