Stablecoin Panics and the Monetary Policy Dimension

The collapse of Terra/UST in May 2022 was not just a large financial loss. It was a demonstration that a significant part of the crypto ecosystem was relying on a monetary instrument with no credible backing, and that when the credibility failed, the collapse was sudden and total.

The Terra system worked as follows: UST was an algorithmic stablecoin — it maintained its $1 peg through a mechanism involving the LUNA token rather than through direct dollar backing. When UST demand increased, LUNA was burned to mint new UST, and when UST demand decreased, UST was burned to mint LUNA. The system required perpetual growth to maintain the peg; in the absence of growth, the mechanism ran in reverse. It was, essentially, a system where the stability was predicated on continued confidence.

In May 2022, large UST withdrawals from Anchor Protocol (which had been offering 20% annual yields on UST deposits, funded by subsidy rather than actual yield generation) triggered a de-pegging. As UST fell below $1, the mechanism to restore the peg required minting LUNA, which increased LUNA supply, which drove down LUNA price, which reduced confidence in UST, which caused more de-pegging. The death spiral played out in about 72 hours. Approximately $60 billion in combined LUNA and UST market cap evaporated. Billions in retail investor losses.

The regulators who had been raising concerns about algorithmic stablecoins were, in this case, right. The Bank of International Settlements and various central bank research departments had published papers identifying the algorithmic stablecoin death spiral risk years before Terra collapsed. The policy response was predictable: renewed attention to stablecoin regulation globally.

The USDC (Circle) and USDT (Tether) cases are different — these are fiat-backed stablecoins where reserves of dollars (or dollar-equivalent assets) are supposed to back each token one-to-one. USDC briefly de-pegged in March 2023 when Silicon Valley Bank, where Circle held a portion of its reserves, was seized by regulators. USDC recovered its peg when the FDIC announced deposit guarantee coverage. The incident illustrated that even "safe" stablecoins have reserve concentration risks.

Tether remains the largest stablecoin and the most controversial. Its reserve composition has historically been opaque, and the CFTC fined Tether $41 million in 2021 for misrepresenting its reserve composition. More recent attestations show a higher proportion of US Treasuries, but the lack of full audit (versus attestation) remains a concern.

Regulatory response has been uneven. The EU has the most comprehensive stablecoin framework under MiCA, distinguishing between e-money tokens and asset-referenced tokens with different requirements for each. The US Congress has been working on stablecoin legislation since 2022 without passing anything. This regulatory uncertainty has pushed some stablecoin activity offshore.

The monetary policy dimension: significant stablecoin issuance means significant demand for dollar-equivalent assets (primarily short-term Treasuries) held in reserve. If stablecoin market caps grow to the tens of trillions, stablecoin issuers become significant actors in short-term Treasury markets. Central banks are paying attention to this.

Stablecoin Panics and the Monetary Policy Dimension

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