Dollar days

A TerraUSD token is meant to be worth a dollar. On Thursday 12 May it was worth 37 cents, and by Friday about 10.^{2TechCrunchTerra resumes blockchain production after halting to prevent hacks amid UST crash12 May 2022,3FortuneThe crypto crash rivals both the internet bubble burst and the Great Financial Crisis, Bank of America says13 May 2022} Its sister token, Luna, which was supposed to absorb the shock, fell more than 99% in a few days to a price of $0.01479, and then to a fraction of a hundredth of a cent.^{2TechCrunchTerra resumes blockchain production after halting to prevent hacks amid UST crash12 May 2022,3FortuneThe crypto crash rivals both the internet bubble burst and the Great Financial Crisis, Bank of America says13 May 2022} Over seven days crypto as a whole lost more than $300bn.^{3FortuneThe crypto crash rivals both the internet bubble burst and the Great Financial Crisis, Bank of America says13 May 2022} Bitcoin dipped to just under $27,000 on Thursday and, on Friday, crept back to $30,000, which in the circumstances counts as good news.^{3FortuneThe crypto crash rivals both the internet bubble burst and the Great Financial Crisis, Bank of America says13 May 2022}

Terra’s stablecoin, UST, was a dollar-shaped promise with no dollars behind it. Conventional stablecoins hold reserves: cash, deposits, short-term paper. UST was called “algorithmic”, which means that its price was defended by code and by confidence in a companion token. When confidence left, the code made matters worse: Terra’s own validators stopped the blockchain on 12 May for two hours, to “prevent governance attacks following severe $LUNA inflation”.^{2TechCrunchTerra resumes blockchain production after halting to prevent hacks amid UST crash12 May 2022} Do Kwon, Terra’s founder, said “the only path forward will be to absorb the stablecoin supply that wants to exit before $UST can start to repeg”.^{2TechCrunchTerra resumes blockchain production after halting to prevent hacks amid UST crash12 May 2022} That is a polite way of describing a bank run.

Not a dollar. TerraUSD (UST), price in dollars; the peg is $1

	UST
Peg	1
12 May	0.37
13 May	0.1

Source: TechCrunch, Fortune²³

We think the lesson is not that crypto is doomed, a view held for most of the past decade and rarely rewarded. It is narrower, and it concerns the word “stable”. A token that is marketed as worth a dollar, and is not redeemable for one from assets held for the purpose, is not a stablecoin. It is a bet that the next buyer will turn up. Call it a coin, call it a protocol, but do not let it borrow the name of money.

Washington has, to its credit, been thinking about this for some time. In November 2021 the President’s Working Group on Financial Markets urged Congress to “act promptly to enact legislation”, and to “require stablecoin issuers to be insured depository institutions”, in order to “guard against stablecoin runs”.^{1US Department of the TreasuryPresident's Working Group on Financial Markets Releases Report and Recommendations on Stablecoins1 Nov 2021} Treasury Secretary Janet Yellen said then that “the absence of appropriate oversight presents risks to users and the broader system”.^{1US Department of the TreasuryPresident's Working Group on Financial Markets Releases Report and Recommendations on Stablecoins1 Nov 2021} On 12 May, with UST off its peg, she told the House Financial Services Committee that stablecoins “present the same kind of risks that we have known for centuries in connection with bank runs”, according to Bloomberg.^{4Bloomberg LawYellen Says Terra Meltdown Shows Crypto-Stablecoin Dangers12 May 2022} It is not often that a regulator has the chance to say “I told you so” with a price chart attached. Congress, to date, has not acted promptly.

The tidiest answer is the working group’s: make issuers banks. We would stop short of it. A bank charter is a heavy instrument, and it sorts firms by identity when the danger lies in what they promise. A payments firm that holds dollars and redeems them at par on demand poses little of the risk that Terra did, and it need not carry the full apparatus of a bank to prove it. Better to write the rule around the promise. Anything offered to the public as redeemable at a dollar should hold high-quality, liquid reserves of at least that value, publish what they are, and honour redemption on demand. Anything that cannot meet that test should be barred from using “stable” or “dollar” in its marketing.

There is a respectable objection. The market, its defenders say, has just done the regulating. Terra’s losses fell on those who chose to hold it; no deposit insurer paid out; no bank failed. Caveat emptor is cheap and, in this case, apparently effective. The trouble is that a rule which works only after the money has gone is not much of a rule. Plenty of those who held UST thought they were holding a dollar. The name told them so. And the damage did not stay in Terra’s corner: a week in which a corner of the market erases more than $300bn is a week in which the neighbours pay too.^{3FortuneThe crypto crash rivals both the internet bubble burst and the Great Financial Crisis, Bank of America says13 May 2022}

Nor is the answer to ban algorithmic experiments. Software that tries to hold a price by clever incentives is a legitimate research problem, in the same way that fixed exchange rates were once a legitimate research problem for central banks. Both failed in public, and the sooner the failures are labelled as experiments, the cheaper they are. If a developer wants to launch a token that tracks the dollar with code alone, the rule should let it, with a prominent warning and a ban on selling it to retail buyers as safe.

Three things should happen quickly. Congress should pass the working group’s central point, which is that payment stablecoins need a federal framework with reserve, redemption and disclosure rules, and settle the charter question as it goes. Regulators should say plainly that a dollar-linked token without reserves is a security or a deposit-like product, whichever fits, and enforce accordingly. And the industry, which has lobbied against exactly this sort of rule for years, should note that its most visible stablecoin failure arrived without any help from a regulator.

Terra’s backers promised a dollar. Next time, the regulator should ask to see it.