By Frances Coppola and Izabella Kaminska
The strangest thing about the Terra/Luna debacle of this month is that the market trusted Terraform Labs to the extent that it did given the history of algo coins in the market, and the history of the issuer specifically.
Terra isn’t the first stablecoin created by Terraform Labs founder Do Kwon – and it isn’t the first to fail, either.
In November 2020, a pair of Terraform Labs coders (performing under the pseudonyms “Rick” and “Morty”) issued an algorithmic stablecoin called Basis Cash (BAC). This was modelled on an earlier algorithmic stablecoin called Basis (previously Basecoin), which was abruptly shut down in December 2018 when its CEO realised that U.S. securities laws would apply to its tokens.
Basis Cash’s stabilisation mechanism relied on a complicated system of bond and share issuance and buybacks. When the BAC stablecoin’s price dropped below $1, the smart contract would issue bonds for sale at the price of 1 BAC, thus withdrawing BAC from circulation. Assuming market demand for BAC did not fall, the reduced supply would, in theory, raise its price to the target $1.
Conversely, if the price rose above $1, new BAC would be issued, firstly to bondholders to redeem their bonds at par, and secondly as a dividend (“seigniorage”) payment to holders of Basis Shares. Again, assuming market demand for BAC did not fall, the increased supply of BAC would, in theory, reduce its price to $1.
But Basis Cash fell off its peg almost as soon as it was issued, and never regained it. By the end of January 2021, it was trading at only 30 cents. Today, it is worth less than a cent.
This was not the only algo coin to fail.
Empty Set Dollar, also based on the original Basis design, was launched at the end of August 2020, It lost control of its peg in December 2020, and by the end of January 2021 was trading at only 19 cents. Like Basis Cash, it is now worth less than a cent.
Terra’s stabilisation mechanism was similarly derived from the original Basis design, while the Iron stablecoin that spectacularly crashed in June 2021 relied on a comparable stabilisation mechanism.
It’s not really surprising that stablecoin issuers keep going back to essentially the same model: people have been fascinated by perpetual motion machines since time immemorial. No one, however, has ever succeeded in making one, because we live in a world of change, and perpetual motion machines only work if nothing ever changes.
In Terra’s case, a change intended to make the machine more stable (the puchase of a bitcoin reserve in March) in fact destabilised it, because it distorted the financial incentives on which the mechanism depended. That being said, if the creation of the new BTC reserve hadn’t destabilised it, something else probably would have.
If it’s financially secure, it’s usually not profitable
So, what was the impetus for issuers like Kwon to focus on these innovations? For the most part, it was probably the realisation that conventional stablecoins – due to their similarities with narrow banks – are exceedingly low-margin businesses. In a lot of cases, they may even be unprofitable.
This is because managing other people’s money prudently and in a way that always protects capital is actually really hard. Even if those assets are fully reserved, some sort of outperformance has to be generated to cover the administration costs. The safest way to do that is to charge fees, but this hinders competitiveness in the market since it generates a de facto negative interest rate. Another option is cross-selling some other service to the captured user base, like loan products. But this gets into bank-like activity.
The bigger temptation, therefore, at least in the first instance, is to invest the funds in your care into far riskier assets (with far greater potential upside) than those you are openly tracking.
But history shows that full-reserve or “narrow” banks eventually become fractional-reserve banks or disappear.
Narrow banks that went fractional
For example, the UK’s Trustee Savings Banks were full-reserve banks specifically created to encourage the poor to save. They were prevented by law from lending and obliged to back all customer deposits with government debt or deposits at the Bank of England. Depositors were guaranteed redemption at par. TSBs were philanthropic institutions, so there wasn’t a great drive to make profits. But even so, there were repeated attempts to change the law to allow them to lend.
In 1975, concerned that TSBs could not compete with lending banks that could offer higher interest rates to depositors, the government gave them the power to lend. Although, once they could lend, they were no longer distinctive. They failed to make headway in the consumer lending market, and deposits gradually slipped away.
In 1984, the TSBs (with the exception of Airdrie Savings Bank) were merged into a single corporation. And in 1986, the corporation was floated. However, it did not survive long as an independent institution. In 1995, it merged with Lloyds Bank. Airdrie Savings Bank survived for longer, but finally closed its doors in 2017.
“The TSB” was re-floated by Lloyds in 2014 and now exists as an independent bank though it is no longer a full-reserve bank. It’s just a medium-sized fractional reserve bank. The only full-reserve bank now remaining in the U.K. is the government-owned National Savings & Investment (NS&I).
Tether’s own fractional reserve journey
In the crypto world, the reserved stablecoin Tether (USDT) is a case study in how full-reserve banking morphed into fractional reserve as its issuer, Tether, tried to find a way of making profits.
Originally, Tether advertised USDT as fully backed by actual dollars: “every Tether is always backed 1-to-1 by traditional currency held in our reserves,” said its website. But in 2019, the website changed. No longer was every Tether backed 1-to-1 by traditional currency. Instead, it was backed by a variety of assets, including opaque third party loans and loans to affiliates:
We now know that the “loans to affiliates” were a loan to Tether’s sister exchange, Bitfinex, to keep it afloat after it lost $850m in the failed shadow bank Crypto Capital Corporation. But the nature and extent of its third party loans remained opaque.
Tether now produces monthly attestation reports disclosing the extent and nature of its assets. The latest one, issued in May 2022 for a reporting date of March 31 2022, reveals that its assets are a mixture of cash, government debt, corporate debt, precious metals, and cryptocurrencies:
The value of issued tokens is US$82,188,190,813.
So USDT is now to all intents and purposes fractionally reserved. Furthermore, the statement of consolidated assets reveals that Tether’s equity is less than 0.2% of total (unweighted) assets. So, much like pre-2008 shadow banks, it is extremely highly leveraged.
When Terra failed, there was a general sell-off in the crypto market. The fully-reserved stablecoins USDC and Binance USD rose above their dollar pegs as investors piled into them to stop their losses. But USDT fell off its USD peg too. In fact, it sold off as if it was a risky asset.
This was partly because of confusion between USDT and UST but it also reflected the market’s view that a fractionally-reserved stablecoin is more risky than a fully-reserved one. USDT is used as a medium of exchange, but not as a safe store of value.
There is now a strong push from both regulators and crypto insiders to force stablecoin issuers to become “narrow banks”, like the Trustee Savings Banks.
Writing in Risk magazine, the IMF’s Manmohan Singh and Caitlin Long, CEO of Custodia Bank, argued that stablecoin issuers should back their coins with central bank deposits and short-term government debt.
Although such an arrangement would undoubtedly be safe, it would, in effect, make reserved stablecoins public sector institutions, dependent on the government for income and unable to diversify their offering to improve shareholder returns. It might be simpler for the central bank to issue a stablecoin itself for use in blockchain-based payments systems.
However, stablecoins don’t have to be backed with risky assets to generate income.
Circle’s USDC is widely used as collateral for crypto lending. Meanwhile, several crypto companies have attempted to create lending products using pledged and deposited stablecoins. Nevertheless, the legal status of these products is unclear: the SEC and several states are pursuing legal action against at least two lenders for failing to register their products as securities, and Coinbase was forced to pull its Lend product before launch when the SEC threatened legal action if the launch went ahead.
If the stablecoin issuer owns a lender, it can make money from lending while providing the stablecoin free of charge.
Terraform Labs, issuer of the failed UST stablecoin, owns a crypto bank, Anchor Protocol, and an investment platform, Mirror Protocol. UST is the native token of both platforms, and on Anchor, Luna is used as collateral for lending. Both have publicly traded “governance tokens”, a.k.a shares. Sounds familiar, doesn’t it?
When UST and Luna were doing well, Anchor and Mirror generated income for Terraform Labs. But now, of course, there isn’t any income. There’s only a huge pile of worthless tokens and unrecoverable loans, and the share prices of the two platforms have crashed to nearly zero.
What few clocked was that there was a run on Anchor Protocol at the time of Terra’s collapse. It was led by the crypto bank Celsius, which had deposited half a billion UST with the crypto lender. All remaining depositors will have lost almost all of their money, not because Anchor is bust (though it probably is) but because UST is.
When a stablecoin dies, the ecosystem that depends on that stablecoin dies too. Trying to generate income from stablecoins carries significant risks: a sudden spike in redemption demands for either a fractionally-reserved or algorithmic stablecoin which, in turn, can collapse the whole house of cards; runs on crypto banks can also knock stablecoins off their pegs.
However, ecosystems built on stablecoins fully-reserved with safe assets or issued by a public institution backed by a tax-raising fiscal authority, would be at much lower risk of failure.
This, of course, is why in the conventional system, money is publicly issued by a central bank and backed by a tax-raising fiscal authority. Do we really need to make the mistakes of the past all over again to prove this point? Apparently, the answer is yes.