Regulators May Be Missing the Weakest Link in Crypto

Policymakers are working hard to put safeguards in place for stablecoins, which are cryptocurrencies meant to have a set $1 value. However, after over a year, they may have overlooked the fastest-growing and arguably most harmful stablecoins of all.

Stablecoins are meant to be the core of cryptocurrency. Traders typically use them as a digital dollar to purchase other cryptocurrencies such as bitcoin, transfer money between exchanges, or sink deposits into yield-paying crypto accounts. Tether and USD Coin, the two largest such currencies, maintain a $1 peg by having dollar-denominated reserves equal to the coins in circulation.

Tether and USD Coin, with a combined $133 billion in circulation, are by far the market's largest participants. TerraUSD, a so-called algorithmic stablecoin that has gained more than 870 percent in the last year, is hard on their tail, behind them with a capital of $18 billion.

Rather than holding $1 in reserves for every dollar of the coin, TerraUSD allows investors to manufacture or "burn" the cryptocurrency in return for a companion token known as Luna. Investors can profit by slight arbitraging variations in the price of TerraUSD, a process that, in theory, should keep the currency's value close to a dollar.

Over the last year, politicians and authorities in the United States, notably the Treasury Department and the Securities and Exchange Commission, have developed plans to establish safeguards around stablecoins. Their concern is that in a crisis, a huge coin may "break the buck," socking investors with losses that will spread into the larger financial market.

According to several experts, the problem is that such suggestions have virtually solely centered on stablecoins such as Tether and USD Coin. A white paper produced in November by a group of authorities, including the Treasury Department, only mentioned algorithmic stablecoins in passing, stating that their plan will focus on more conventional stablecoins "because of their more widespread adoption."

According to CoinMarketCap.com, TerraUSD had a market circulation of $2.8 billion on the day the data was released. Within a month, it had nearly quadrupled in size. TerraUSD and other algo Stablecoins now appear to be a big blind hole in regulators' recommendations, with a market valuation of $18 billion.

"Algorithmic stablecoins are fundamentally weak, have a higher risk, and receive less regulatory scrutiny," said Mark Hays, senior policy analyst for Americans for Financial Reform, a Washington, D.C.-based investor advocacy organization that has criticized various cryptocurrency initiatives. "It raises the possibility that someone may lose their money."

A representative for the Treasury Department declined to comment. Similarly, other legislators' plans have neglected or even deliberately omitted the establishment of safeguards around algorithmic stablecoins.

Senator Pat Toomey (R-PA) introduced draft legislation earlier this month that would standardize the disclosures that conventional stablecoin issuers must provide about their reserves and subject them to periodic audits, among other things. Toomey's plan, on the other hand, clearly focused on "payment stablecoins," such as USD Coin or Tether, that could be changed into traditional "fiat" currency—excluding algorithmic tokens such as TerraUSD from a regulatory framework.

Another point of concern: TerraUSD's spectacular rise has been driven entirely by investor desire to deposit cash in Anchor, a decentralized finance system created with Terra that provides a roughly 20% dividend.

That level of output may not be sustainable. In addition, a drop in demand for Anchor might lead to traders selling their TerraUSD, which is not backed by tangible assets. Indeed, TerraUSD supporters have stated that they will purchase up to $10 billion in bitcoin to backstop the stablecoin in the event that the algorithm fails.

Other algorithmic stablecoins have attempted to generate demand by promising high-yielding promises similarly. Tron DAO, another decentralized organization, said on Thursday that it would introduce USDD, an algorithmic stablecoin with a reserve that pays a 30% interest rate.

According to algorithmic coin skeptics such as University of Calgary law professor Ryan Clements, one concern is what would happen to the coins if those yields turn out to be false and investors rush out of the coins in droves. "Even Luna fans see the possible concern if Anchor is unable to pay out those yields," Clements added.

Fears about algorithmic stablecoin meltdowns aren't just speculative. Beanstalk, an algo-coin, failed last week after someone abused its programming to siphon out more than $180 million in digital assets.

It's unclear how regulators might keep the coins under control. Algorithmic stablecoins are often administered by computer code on "decentralized finance" networks that are not controlled by a single corporation.

This might make it harder for agencies and lawmakers to establish a regulatory entity, while opponents point out that it's typically easy to discover one or two huge entities in control. The projects' founders have also tended to stay anonymous or to establish themselves in crypto-friendly governments overseas.

However, when investors pour tens of billions of dollars into the coins, they may become too tough for authorities to ignore.