Stablecoin stability and regulation

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02/01/2023 Article
Ken Katayama NRI - Nomura Research Institute Senior Chief Researcher

TerraUSD debacle

In early May 2022, the stablecoin TerraUSD (UST) suddenly crashed, losing its peg to the US dollar.

I define “stablecoin,” a term without a clear consensus definition, as a store of value and/or medium of exchange that aims to maintain parity with a fiat currency and is used on a permissionless blockchain. I classify stablecoins as fiat-backed, crypto-backed or algorithmic based on the mechanism by which they seek to maintain a stable value. Fiat-backed stablecoins are backed by safe financial assets such as bank deposits or government bonds and guaranteed by their issuer to be redeemable on demand. Crypto-backed stablecoins aim to maintain a stable value through overcollateralization with cryptoassets in accord with an issuance protocol. Algorithmic stablecoins rely on arbitrage against other cryptoassets to maintain a stable value.

UST was an algorithmic stablecoin. Specifically, it was structured to maintain a stable value through arbitrage against LUNA4), a second cryptoasset governed by the Terra issuance protocol. The Terra ecosystem attracted capital inflows by developing various UST-based services, including the Anchor lending/borrowing protocol, which offered a 20% APR to lenders. However, whales drove down UST’s value by liquidating their holdings. In response, arbitrageurs exchanged UST for LUNA, leading to massive LUNA issuance. In other words, the mechanism that was intended to maintain a stable exchange value between UST and LUNA ended up triggering a hyperinflationary death spiral.

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