Unpegging of Terra’s USD stablecoin likely to boost calls for regulation

  • By Zilla Efrat

The failure of the algorithmic peg mechanism fixing the price of Terra’s USD stablecoin (UST) and the unmooring of Tether from its USD peg expose the fragile nature of private stablecoins and will accelerate calls for regulation, says Fitch Ratings.

Stablecoins are cryptocurrencies that are meant to be pegged to fiat currencies like the US dollar. In the cases of USD-pegged stablecoins, their prices are supposed to be US$1 at all times.

Fitch Ratings notes 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.

UST lost its peg to the US dollar on Tuesday and then plummeted all but wiping out the US$30 billion Terra ecosystem.

A wave of fear gripped traders, leading to a steep fall across all cryptocurrencies and briefly spread to other stablecoins, including Tether’s USDT.

The largest stablecoin, Tether (USDT), also diverged from US$1, though more marginally. It fell to 94.55 cents from its intended 1-to-1 peg to the US dollar on Thursday before recovering to just above 99 cents.

“We expect recent developments to lead to increased calls for regulation of stablecoins,” says Fitch Ratings.

“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.”

Fitch Ratings believes that stablecoins backed by reserve assets with clear fiat currency value face a fundamentally different set of credit issues to algorithmic stablecoins.

“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.”

Fitch adds: “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.”

Fitch observes that 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,” says Fitch.

“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.”

Fitch says 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 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.”