Terra Luna Crash not a Government Issue

Terra Luna Crash not a government issue

The crypto market is suffering a severe correction. One asset feeling the pinch is LUNA, which along with its related nonprofit the Luna Foundation Guard (LFG) govern and support the stablecoin TerraUSD (UST). [Update: After the Terra Luna crash, authorities in South Korea and the U.S. are investigating founder Do Kwon].

UST is an algorithmic stablecoin. Instead of being backed by assets such as U.S. dollars, government securities, or commercial paper the volatile digital asset LUNA backs it. Users can theoretically always exchange $1 of LUNA for $1 of UST, which is how it maintains it dollar peg. But this depends on LUNA being valuable enough to support the exchange. According to CoinDesk, the Terra crypto ecosystem has dropped 53 percent in the past 24 hours. This has caused UST to drop as low as 35 cents, at the time of this writing it is trading around 70 cents.

UST is fighting for its life and it’s anyone’s guess whether LGF measures to save it, including lending out $1.5 billion in Bitcoin to support the peg, will be enough.

Terra Luna crash did not spur contagion

Importantly, other stablecoins are holding their $1 peg, including DAI, which is tied to Ether, the second largest digital asset. In fact, for the absolute blood bath May has become in crypto markets, stablecoins have proved resilient.

Nonetheless, under the familiar political mantra ‘Never Let a Crisis Go to Waste,’ Treasury Sectary Janet Yellen seized on UST’s troubles to call for stablecoin regulation yesterday in Congressional testimony. Stating the current regulatory regimes, “don’t provide consistent and comprehensive standards for the risks of stablecoins.”

Congress should slow down before blindly jumping into reactive stablecoin lawmaking. First, the President’s Working Group (PWG) released their report on stablecoins last November. It does not even cover algorithmic stablecoins like UST, as Senator Pat Toomey (R-PA) correctly reminded Sectary Yellen. As the PWG report described, these stablecoins are a niche subset that have not gained the importance of what the PWG called “payment stablecoins”—those backed by real-world assets like U.S. dollars and treasuries.

PWG Report does not cover algorithmic stablecoins

Thus, the PWG’s recommendation, that stablecoin issuers become federally chartered, FDIC-insured banks would not apply.

Second even assuming the PWG applied to algorithmic stablecoins, the parade of horribles the report envisions has not occurred. The PWG warned of stablecoin runs turning systemic and even threatening the broader economy:

The prospect of a stablecoin underperforming as expected could result in a “run” on that stablecoin – i.e., a self-reinforcing cycle of redemptions and fire sales of reserve assets. Fire sales of reserve assets could disrupt critical funding markets, depending on the type and volume of reserve assets involved. Runs could spread contagiously from one stablecoin to another, or to other types of financial institutions that are believed to have a similar risk profile. Risks to the broader financial system could rapidly increase as well, especially in the absence of prudential standards.

Terra Luna crash will not harm the larger markets

Third, the entire stablecoin market stands at a relatively miniscule $173 billion. The Fed’s, Financial Stability Report, released on May 9, claims total asset market vulnerable to runs is $19.1 trillion.

Congress should be wary of creating another financial regulatory disaster like Dodd-Frank, as reactive measure to a market correction.

If UST falls, it should be a lesson for traders. Do not back a stablecoin with a relatively unproven reference asset and outlandish yields. Of course, people should be able to bet on riskier assets but their failure should not trigger a Congressional response.

By Jossey PLLC

This post originally appeared on the blog of the Competitive Enterprise Institute on May 12, 2022, https://cei.org/blog/terra-troubles-should-not-spur-stablecoin-regulation/

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