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Why Terra’s Fall Offers a Unique Opportunity to Create a Better Stablecoin Environment

·9 min read

Don't miss CoinDesk's Consensus 2022, the must-attend crypto & blockchain festival experience of the year in Austin, TX this June 9-12.

No topic in the crypto world has been more prominent in recent weeks than stablecoins. Investors, regulators and crypto service providers, among others, wonder what the future holds for them. As stablecoins have a combined market capitalization of easily over $100 billion, there’s much at stake.

Stablecoins are a cornerstone of the crypto industry. But following the recent troubles of terraUSD's (UST) stablecoin, one of the most widely used algorithmic stablecoins, trust in these assets has eroded.

Changpeng Zhao is CEO of the cryptocurrency exchange Binance, which offers a stablecoin. Zhao is a speaker at Consensus 2022.

The effects of UST's depegging from the U.S. dollar have been reported widely, but a vast amount of misinformation is circulating.

Stablecoins have been among the most revolutionary aspects of the crypto ecosystem. They’ve empowered the unbanked and created a semistable space in an incredibly volatile industry. Stablecoins have also established common ground between central banks, regulators and decentralized players.

Nevertheless, we need to stay grounded. Through informed decision-making, users can reduce their exposure to the wild risks seen with Terra. So while the current atmosphere may seem hostile, we have a unique opportunity to show the world that secure, regulated stablecoins exist.

Why stablecoins are essential

Stablecoins are incredibly important in the crypto ecosystem. Whether you're a simple "HODLer" investing spare change or a veteran trader, you can find a need for stablecoins.

For many in the crypto world, remembering a time without stablecoins is difficult. Creating a successful way to maintain stable value without off-ramping into fiat was revolutionary. Exiting a position into fiat currency can take days and increase costs. With this in mind, keeping value stable and on-chain in a trusted way can hugely improve liquidity.

Read More: The Fall of Terra: A Timeline of the Meteoric Rise and Crash of UST and LUNA

Stablecoins also bring vital financial services to the unbanked and sufferers of rampant inflation. Rising consumer costs must no longer devour your savings when you can maintain their value with a reputable stablecoin. Closely related are remittances, as family and friends can cheaply and almost instantly transfer money globally with a stablecoin.

Don’t underestimate stringent requirements

I've often encountered the mindset that stablecoins offer a crypto panacea. The top 10 coins and tokens by market capitalization have always maintained a significant stablecoin presence. They've even provided ways to earn tempting, high annual percentage yields (APYs) in the crypto world with a stable asset. It almost sounds too good to be true.

But as we've seen with Terra, the house of cards can quickly collapse. The benefits of stablecoins are immense, but they can be doomed to fail without responsible, regulated mechanisms to support them. To me, there are several issues at play here, and they don't all involve the stablecoin issuer.

First, I want to discuss a crucial point many people don't understand: Not all stablecoins operate with the same principles.

Reserves-backed stablecoins

Most large stablecoins available are reserves-based. Some coins, like Binance USD (BUSD), maintain cash reserves that are periodically attested, regulated and guaranteed. Others hold various assets, including commercial paper, bonds and crypto. Even within this category, the ratio of reserves to issued coins can be a contentious topic.

For full stability, a reserve level of 100% should also be maintained. Of all available options, reserves-backed stablecoins typically provide the most user security.

Algorithmic stablecoins

Another commonly used model is algorithmic-based. You'll likely have heard the term recently, as this was terraUSD's (UST) operating model. These coins have little or no collateral backing and use algorithms to incentivize investor behavior. By affecting market demand and supply, an algorithmic stablecoin attempts to maintain its peg.

Terra, for example, tried to peg each coin to the U.S. dollar by being transferable at a 1:1 rate with $1 of LUNA. Converting 1 UST to $1 of LUNA and vice versa would burn the coin you provided, effectively manipulating supply.

Even with the brief description, the cracks are already visible. Pegging to the U.S. dollar through a seigniorage mechanism with your own token is a dangerous position. Acting like a central bank may look tempting, but we already know the limits their real-life counterparts have.

Terra exposed the algorithmic method's flaws

Many people in the crypto industry understood the Terra model’s limitations even before the protocol’s crash. Now Terra’s vulnerabilities are more widely known.

Terra printing money like the Federal Reserve didn't create value; it diluted it for existing holders. Having a small number of reserves also made repegging the stablecoin difficult at best. Also, tempting 20% APY returns on Anchor staking incentivized demand for a stablecoin that had little backing in value.

How did we get to where we are today?

  • So with these flaws visible, why was everyone jumping on the Terra train? Consider the following reasons. There was a general misunderstanding. I often wonder if many Terra investors understood what was maintaining its peg and generating such high APYs. As with any investment, you should always fully understand what you're investing in and how it works. To me, education plays a huge role in ensuring this never happens again.

  • Investors dreamed of creating quick monetary value. Some crypto enthusiasts have critiqued the traditional central bank model and derided it for its inflationary practices. However, when given a chance to operate like a central bank themselves, the blockchain community forgot the lessons from years of economic history, leading to an unsustainable tokenomic model with flawed incentives.

  • The community overlooked the importance of regulation. While many crypto enthusiasts see regulation as a foe, it can actually be a friend. To me, the recent Terra situation shows how unregulated stablecoins can dramatically fail without regulation.

The importance of regulatory cooperation

The regulatory process is not perfect and must change. The relationship between regulators and stablecoin issuers must develop and grow.

An existential fear of stablecoins?

A number of media pundits have inferred that central banks, governments and regulators view digital assets pegged to fiat as an existential threat. This is a misperception. The security of these institutions’ national fiat currencies and sovereignty isn’t at risk. However, this sentiment may have led to a scramble to create central bank digital currencies (CBDC), heightened fears about stablecoins and pushed stablecoin projects out of the market.

Stablecoin fear is misguided

Much of this fear is, however, misguided. Not all stablecoins are created equal, and many provide a superior experience through sound reserves, oversight and attestations. A 100% reserve-backed stablecoin is easier for a regulator to stomach than an algorithmic one creating dollar value out of nothing.

Regulators need support to alleviate any fears

As much as regulators may worry about the outcome, the reality is that properly managed stablecoins currently aren't a threat to financial stability.

Read More: The Collapse of UST and LUNA Was Devastating, but There Is Still Hope for Crypto

The crypto community must be willing to engage with regulators, educate them and demonstrate responsible stablecoin models to foster a better understanding. We must also be mindful of regulators’ concerns and learn from their years of financial experience.

How can we all work together?

As an industry, we can begin to ease regulatory concerns by encouraging a broader debate. While financial stability is essential, it's not the only factor at play here. Greater consumer choice, competition and innovation will improve the stablecoin experience for all stakeholders.

With innovation and competition come new players in the market, but a natural aversion to change can leave regulators reluctant to work with new market entrants. So far, we've seen an approach that tends to prioritize those legacy winners deemed “too big to fail.” This has led to the protection of incumbents in the name of stability. Often, newcomers provide a broader perspective on various topics that regulators have in their sights, including financial crime, financial stability, market integrity and consumer protection.

Real-deal stablecoins already exist

So what's the ideal situation for a stablecoin? As we already covered, the most reliable stablecoin is fiat-backed. Taking this further, reserves should back the issued asset 100%, be attestable and maintained in cash or cash equivalents. Finally, we can't forget the role of regulators in ensuring these assets maintain high financial standards and provide appropriate backing.

USDP from Paxos is one example that meets all our criteria. It holds monthly attestations of its reserves and guarantees users can always switch between USDP and USD at a 1:1 rate. USDP also has a regulated status through the ​​New York State Department of Financial Services (NYDFS).

To ensure we provided the same safeguards with BUSD, we chose Paxos as our issuance partner. This cooperation provides BUSD holders with the same benefits USDP offers:

  • A 1:1 secure and compliant USD-backed stablecoin regulated by the NYDFS.

  • Actual cash and cash equivalent reserves consisting of 96% cash and 4% U.S. Treasury bills.

  • Federal Deposit Insurance Corp.-insurance. If BUSD is compromised, the reserves are insured and safe. Users don't need to worry about losing any value on their BUSD holdings.

  • Monthly attestation of the reserves. These reports independently verify the entire BUSD token supply is backed by fiat in U.S. banks held and managed by Paxos.

Read More: Luna (LUNA) vs. Luna Classic (LUNC): What Is the Difference?

Let’s make the most of this period of reflection

Terra's situation has profoundly affected the crypto industry in value, trust and reputation. Nevertheless, there is a great opportunity to build back stronger. During the current correction, we have time to develop real applications as a basis for solid growth rather than high APY pipe dreams.

Regulators are even keener to further their dialogue with stablecoin issuers. In a way, the market has separated exceptional from lesser models. We can be thankful for that.

Crypto has developed at such a rapid speed that regulation is still fragmented and lacks harmonization. The situation constantly evolves, and so does our approach to meeting all new requirements.

When it comes to stablecoins, we're proud to lead the way in regulation through BUSD. We're also happy to show the whole industry how they can responsibly issue stablecoins. The recent crash and Terra situation have created an opportunity for us all to cooperate, learn and educate one another. Let's not miss this chance to nurture true stablecoins that regulators and users can rely on and deserve.

Read More: Terra Snapshot Expected This Week. Here’s How 'New' Luna Will Be Distributed