How the TerraUSD Collapse Is Affecting Financial Markets

By Brian Laverdure

June 07, 2022

While the collapse of the TerraUSD stablecoin has captured the most attention and headlines, it was not the only stablecoin to fail during the market downturn. Here’s a look at the impact of the Terra decline on the stablecoin sector and what’s next for the crypto markets.

Stablecoin Contagion

The Terra sell-off quickly spread to other stablecoins. USDX, with a market cap of nearly $200 million prior to the crash, failed because it had UST as part of its collateral reserves. So when the value of UST toppled, so too did the value of USDX. It has not yet regained its peg and was valued at roughly $0.94 as of June 4.

With all the turmoil initiated by UST’s troubles, attention turned to the largest stablecoin, Tether. Tether’s role in the wider crypto ecosystem cannot be overstated. It is a vital component that facilitates trading around the globe, and it had over $80 billion in circulation prior to the market crash.

Tether has been clouded in mystery ever since its inception, with many raising questions about the nature and source of the assets it claims to maintain in its reserves. In fact, the Commodity Futures Trading Commission and the New York state attorney general pursued Tether for misrepresenting that it was fully backed. They fined Tether, and its associated exchange called Bitfinex, $42 million and $18.5 million, respectively, and barred Tether from operating in New York.

On the morning of May 12, Tether broke the buck when it dropped to $0.95. The decline set off new fears among users and spurred many to seek redemptions. Investors pulled out $10 billion, shrinking the amount in circulation to about $73 billion.

What will happen in the coming months may hinge on how much information Tether reveals in its next attestation. The most recent attestation—dated March 31, 2022—says the “consolidated reserves held for its digital assets issued exceeds the amount required to redeem the digital asset tokens issued.”

However, the accounting firm that completed the attestation acknowledged that it “did not perform procedures or provide any assurance at any other date or time in this report.” The attestation was finished long before the recent market volatility, so investors will likely be eager for additional information in upcoming reports.

In particular, the new report reveals that Tether held nearly $5 billion in other assets, including digital tokens, at the end of March. Given the recent market turmoil, investors may question whether those digital tokens maintained their value.

Market Impact and Outlook

Since early May, the total crypto market has contracted significantly, falling in value by more than $500 billion to $1.29 trillion. Leading assets, like bitcoin and ether, have seen steep declines in value.

The decentralized finance (DeFi) ecosystem has witnessed a weakening in overall values and activity. After climbing to more than $100 billion just months ago, the amount deposited in DeFi protocols (or “total value locked”) has fallen by about 20% to around $56 billion.

While the DeFi ecosystem has certainly been dealt a heavy blow with the volatility and Terra’s collapse, it seems unlikely to be a fatal blow. DeFi will likely persist and continue to present serious risks to consumers, the financial system, and U.S. national security. Community banks may also be disintermediated by this growing world of shadow banking.

What’s Next?

As the dust from TerraUSD’s collapse settles and the industry takes stock of the causes, policymakers and market stakeholders are focused on what the failure means for the future of stablecoins.

In the immediate future, the total supply of stablecoins will likely be somewhat limited due to decreased crypto trading. Stablecoin issuers will maintain their efforts to expand beyond crypto trading into cross-border transactions or even processing payments for the cannabis industry.

TerraUSD’s demise did not eliminate all the other algorithmic stablecoins or the motivation among crypto advocates to create a decentralized money. One project calling itself the Decentral Bank is moving forward with plans for a stablecoin on the NEAR blockchain that claims to provide “fast transactions, cheap trans-border payments, and outstanding price stability.”

The name of that project—“Decentral Bank”—should in itself give bankers and policymakers pause, and it points to why a regulatory infrastructure is needed. Decentralized autonomous organizations are not banks. The fact that a DAO can masquerade as a chartered financial institution is disquieting, and regulators should take notice of crypto entities that use misleading language.

In that regard, ICBA’s next post on the TerraUSD collapse will explore how it is affecting the regulatory response to stablecoins and what the reaction will mean for community banks.