Moon and Back Again: Terra, Luna, and the Legal Framework for Stablecoins

To understand the utter meltdown of the $UST (Terra) stablecoin and its implications on the law and regulatory environment, we first need to take a step back. Crypto contains something of a paradox. On the one hand, many crypto natives view it as a replacement for government / financial institution controlled currency. That was explicitly the aim in Satoshi Nakamoto's white paper. On the other hand, literally everything in crypto is benchmarked against the U.S. dollar. The tension this paradox creates is compounded by the fact that most cryptocurrency is highly volatile. When you spend 10,000 bitcoins to buy a pizza and then watch its value go up by 100,000%+, you now want to throw up your pizza.

Precisely because people do not want to spend assets that may become much more valuable over time for everyday transactions, crypto developers created stablecoins. For purposes of this article, a stablecoin is cryptocurrency explicitly pegged to the U.S. dollar that enables the benefits of bitcoin (immutable, instant, peer-to-peer transactions) without its volatility. This allows users to immediately revert highly volatile crypto assets (e.g., bitcoin or Eth) to stable "dollars" without having to use a fiat off-ramp through the traditional financial system (at least, until they want out of crypto entirely).

That brings us to the creation of $UST (aka Terra) and its counterpart $LUNA, a stablecoin ecosystem created by the Terraform Labs with heavy guidance and influence from Do Kwon. But to understand $UST and $LUNA, we need to understand stablecoins more generally. So, some background.

There are currently two basic categories for how a stablecoin can work:

1. back stablecoins denominated in U.S. dollars with actual U.S. dollars (or other valuable collateral) held somewhere in reserve ("collateralized stablecoins")

2. use an algorithm to incentivize trading in precisely the right way so that the cryptocurrency's value is constantly pushed back to US$1.00 ("algostables")

Collateralized stablecoins have the advantage, in theory, of always, 100% of the time, having at least some real U.S. dollars (or other valuable collateral) to give to anyone who wants to turn in their stablecoin. Note that it doesn't necessarily mean that there is a whole dollar of value for every stablecoin, but there is at least something there; it cannot go to absolute zero.

Algostables make no pretense that there is any amount of actual fiat money or other valuable collateral backing them. Instead, they use economic incentives to try to push the price people are willing to pay for the stablecoin back to $1.

Now, how the dumpster fire happened. In short, Terraform Labs created two tokens. One is the algorithmic stablecoin pegged to the U.S. dollar, $UST. The other has no peg at all, $LUNA. Through a protocol on-chain, you can always exchange one $UST for $1 worth of $LUNA, and you can always exchange $1 worth of $LUNA for one $UST. Thus if there is too much selling pressure on $UST and it slightly depegs to $0.95, traders can snap it up at that price and instantly trade it in through the protocol for $1 worth of $LUNA — an instant profit (at least, on paper) of $0.05 for every $0.95 invested. This works in reverse too, so if $UST gets up to $1.05m, traders can swap out $1 of $LUNA through the protocol for one $UST worth $1.05, sell it, and push the price of $UST back down.

When traders use the protocol to make the swap, the protocol burns the turned-in $UST or $LUNA, reducing its supply, while minting more of the corresponding token. When trading in $1 worth of $LUNA, the protocol mints one more $UST, and burns the $LUNA that was traded in. When trading in $UST, the protocol burns the $UST and mints more $LUNA. This is where it gets tricky. When traders redeem their $UST for $LUNA, the protocol simply creates more $LUNA at the then-existing ratio of $LUNA to one $UST. So if $LUNA is worth $100, trading in one $UST creates only 0.01 $LUNA. But if $LUNA is worth only $0.0002 (its current trading price as of writing), the swap of one $UST would mint 5,000 $LUNA. At one low point, swapping in one $UST minted 111,111 $LUNA. The supply can balloon if $LUNA remains at these low valuations, which is exactly what happened as more people swapped in their $UST.

When most people agreed $LUNA had meaningful value, the system worked, and $LUNA functioned sort-of like collateral for $UST since people could see that swapping in $UST when it started to go down would get them something they could sell for a bit more. However, in times of market stress when a lot of people want to sell both $UST and $LUNA for dollars (or other crypto), a death spiral results. People holding $UST are selling it, pushing it off its peg. People holding $LUNA are doing the same, pushing its price down.

Meanwhile, people hoping to take advantage of the arbitrage protocol are swapping in their depegged $UST worth less than $1 for what they hope is $1 worth of $LUNA. But doing so causes ever more $LUNA to be minted, further pushing down $LUNA's price. And since it takes $1 worth of $LUNA to trade for one $UST, if $UST remains depegged from $1, no one wants to swap $LUNA for $UST, especially as its price spirals down, requiring ever more $LUNA to complete the swap. It would currently take about 5,000 $LUNA to swap through the protocol for one $UST, but $UST is currently worth only $0.09. Most people do not like setting money on fire, so no one is doing this. (And on-chain swapping has apparently been turned off anyway.)

So the only way out is to sell the $LUNA you've created, generating more downward price pressure, and down $LUNA goes to zero. Meanwhile, people are still selling their $UST because they can see that the system is breaking and the fundamental promise of being able to trade $UST for slightly more valuable $LUNA in the case of a depeg is vanishing (and currently gone because swaps are disabled), further pushing $UST off its peg. That is how you end up with charts like these:

Meanwhile, another stablecoin, Tether (pitched as a fully collateralized stablecoin) also saw the market chaos briefly knock it off its peg to about $0.95, albeit more temporarily, as spooked crypto traders cashed out more than $3 billion worth of the stablecoin in a single day. That amount was a small fraction of the $82.9 billion that were outstanding. Ryan Browne, CNBC.com, World's Biggest Stablecoin Regains Dollar Peg After $3 Billion in Withdrawals __ (2022.05.13). One likely cause of the small rush to exit Tether amidst watching $UST crash was the barely year-old settlement Tether reached with the New York attorney general.

In that settlement, the New York AG revealed that despite Tether's prior representations that its stablecoin was "backed one-to-one by U.S. dollars in reserve," in fact "Tether made false statements about the backing of the 'tether' stablecoins, and about the movement of hundreds of millions of dollars . . . . 'Tether's claims that its virtual currency was fully backed by U.S. dollars at all times was a lie.'" NY Attorney General, Attorney General James Ends Virtual Currency Trading Platform Bitfinex's Illegal Activities in New York (2021.02.23). So you can imagine how watching one stablecoin implode would make traders skeptical about the integrity of another that had lied about being fully backed.

In any event, despite the surge in redemptions of Tether for dollars, Tether was able to regain its peg by Friday and was trading normally, suggesting traders had sufficient confidence that their redemption orders were being honored 1:1 for dollars.

Zooming back out, creating a stablecoin is to essentially reinvent the banking wheel in a different format. People give you their real dollars for a coin that trades at the value of a U.S. dollar. At any point in time, you can turn your coin in and withdraw real U.S. dollars. If this sounds familiar, it's because this is how traditional banking works. You deposit your real dollars in a bank, and they promise to give you real dollars (or send real dollars where you want them) whenever you ask. But if you leave money in your account that's not used, the bank uses that money to make loans or investments.

Banks have not always been terribly good at predicting how many actual dollars they need to have on hand in times of market stress to give to their depositors. So, for example, when the stock market crashed in the 1920s initiating the Great Depression, lots of people wanted to get hard cash out of their banks all at the same time. The banks were not ready for this. They ran out of cash to give. This is known as a "bank run" and is a risk that banks try to mitigate on their own and by complying with governmental mandates about "safety and soundness." Because the banks ran out of cash, they also could not operate. Many banks ended up liquidating, and many people did not get remotely near the amount of money they had given to the bank.

People really did not like this outcome. As a result, the FDIC was born. Now if your bank fails, the FDIC steps in and will give you up to $250,000 of your deposits. $250,000 in cash covers almost everyone, so people feel very safe putting their money in a bank account.

There is no FDIC for stablecoins, however. This means that stablecoin issuers run exactly the same risk (and more) as a bank does when too many people show up and demand to get real dollars in exchange for their stablecoins all at the same time — at least, if there is not a 1:1 ratio of dollars (or other assets) to exchange. As we saw with $UST, when there is nothing (or only assets rapidly dropping to nothing) of value to offer people in this situation, they lose a tremendous amount of wealth almost instantly. And even in the case of Tether, which claims to be highly collateralized, it lost its peg briefly as people moved to redeem billions of Tether for dollars.

In the U.S., federal regulators have been picking up on this risk in crypto markets for some time now. Let's explore what regulators are likely to do next.

Literally while $LUNA and $UST were crashing, U.S. regulatory heads were calling for stablecoin regulation in the very near future because of the implosion everyone was witnessing. Even the normally outspoken friend of cryptocurrency, SEC Commissioner Hester Peirce, indicated regulation was imminent for stablecoins. Marc Jones & Katanga Johnson, U.S. News, U.S. SEC's Peirce Sees 'Movement' on Stablecoin Regulations __ (2022.05.12). She did note, however, that regulation needs "to allow room for there to be failure." Id.

Janet Yellen, Secretary of the Treasury, opined on May 10 during congressional testimony that it would be "highly appropriate" to regulate stablecoins by the end of the year due to the "many risks associated with cryptocurrencies" and the need for "a consistent federal framework." Jacquelyn Melinek, TechCrunch.com, US Treasury Secretary Janet Yellen Pushes for Stablecoin Regulation by End of Year __ (2022.05.10).

Two days later Yellen followed up on those remarks in additional congressional testimony, calling again for a "federal prudential framework" for stablecoins precisely because $UST had lost its peg. She did note, however, that "there are significant differences between" algorithmic and collateralized stablecoins that should inform the regulatory approach. Yellen also said — although quite tentatively — that the Treasury would be open to considering alternatives to having stablecoins exclusively issued by and domiciled in banks. YouTube.com, Hybrid Hearing - The Annual Report of the Financial Stability Oversight Council __ (2022.05.12).

That tentative concession differs significantly from the strong recommendation by the President's Working Group, FDIC, and OCC from just six months ago. That report concluded that only banks should issue stablecoins and that they must be backed 1:1 by actual dollar reserves. The report also concluded stablecoin regulation should include three other major provisions:

• requiring custodial wallet providers for stablecoins to be subject to federal oversight;

• limiting those wallet providers' ability to affiliate with other commercial entities and on their ability to use transaction data; and

• making sure the federal regulator supervising stablecoins can impose risk-management standards on issuers and has the authority to implement standards to promote interoperability among stablecoins

If implemented, these recommendations would work a dramatic contraction of both the field of entities in the U.S. that are able to offer stablecoins and the regulatory burden on those entities to implement one. (And query the wisdom of limiting issuers to those with a profit motive.)

It also fails to account for what impact this sort of regulatory change would work on a company like Circle, which is decidedly not a bank but is a licensed money transmitter in 46 states, D.C., and Puerto Rico, and is the creator of the $51B market cap $USDC. Becoming a licensed money transmitter is no joke, and comes with significant regulatory oversight at both the state and federal level. However, it does not require you to have capital reserves in the same way a bank is required to have capital reserve to meet liquidity demand in times of stress.

In any event, the PWG's report is not the end of the story, as there are multiple members of Congress that have pitched competing initial proposals to regulate stablecoins. So, where are we today?

• limit stablecoin issuers to only an "insured depository institution that is a member of the Federal Reserve System." So, basically only banks and credit unions.

• outlawing any stablecoin related commercial activity "without obtaining written approval in advance . . . from the appropriate Federal banking agency, the [FDIC], and the Board of Governors of the Federal Reserve System." If this sounds like stifling the prospect of rapid deployment of new stablecoin products, believe your ears.

• require advance approval for issuing a stablecoin, getting written approval to issue it from (again) the "appropriate Federal banking agency, the [FDIC], and the Board of Governors of the Federal Reserve System." Almost certainly only banks since that's who the FDIC oversees.

• require reporting of an "ongoing analysis" to the Fed, FSOC, and Office of Finance Research "on any potential systemic impacts or monetary policy implications of the stablecoin." This is odd. Why would the stablecoin issuer do this analsyis? It could provide data, but government entities are the ones who should be doing this job.

• allows the issuer to get a master account to the Federal Reserve System and makes the issuer "eligible to receive all benefits and access to services associated with such account."

• requires reserves deposited into a Federal reserve bank in "an amount equal to the nominal redemption value of all outstanding stablecoins issued by the issuer" except for the value of any oustanding stablecoins that "are insured deposits." This suggests that at least some portion of issued stablecoins could be considered "insured" by the FDIC, although where those deposits would be held to qualify for this status is entirely unclear from this proposal.

So far this act has gone nowhere and its only legislative history is its introduction. It has strong parallels to the PWG's proposal, and is overall nearly as restrictive. It will likely be the starting point in discussion for congressional democrats given its sponsors.

Just last month, Sen. Patrick Toomey (R-PA) introduced a discussion draft of a bill to regulate stablecoins, the Stablecoin Transparency of Reserves and Uniform Safe Transactions Act of 2022. Toomey has been friendly to crypto for some time, so it's not too surprising that this proposal offers significantly more flexibility to the industry. Its key features:

• limits issuers of stablecoins, but less broadly, permitting three categories: (1) money transmitting businesses authorized by State banking authorities to issue stablecoins; (2) newly defined "national limited payment stablecoin issuers"; or (3) insured depository institutions (banks/credit unions).

  • The new category of national issuers means anyone who issues stablecoins and receives a license from the OCC, including national trust banks and State-chartered trusts.

  • The OCC can only deny an application for a license if it determines "the applicant would be unsafe or unsound" based on its financial condition, the "general character and fitness of the management of the applicant," or the risks outweighing the potential benefits to consumers.

  • The act limits the regulatory authority of the OCC to issue regulations on capital, liquidity, governance, and risk-management requirements.

• imposes significant disclosure requirements on issuers, including the specific assets backing the stablecoin, policies for redemption, and CPA attestations. Disclosure requirements are good, as they boost consumer confidence that they can redeem their coins for dollars.

• prohibits national limited payment stablecoin issuers from doing anything except issuing and redeeming stablecoins, and any incidental activities related to to doing so. They specifically cannot make loans "or other extensions of credit." This seems to be a risk management strategy on the one hand (prevent immediate leverage), but also a boon to banks that these stablecoin issuers will not be able to give loans that, presumably, banks will.

• provides that traditional depository institutions can compete with these new entities by getting equal regulatory treatment if they create a discrete subsidiary for this purpose.

• requires the stablecoin to be backed with assets that are at least 100% of the par value of the outstanding stablecoins and are M1 money (cash/cash equivalents)

• gives the stablecoin issuer access to the federal reserve system. This is huge, as it further assures that the stablecoin will be effectively collateralized and "depositors" protected.

• exempts stablecoins issued pursuant to this section from the definition of a security under the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940. Also huge and clears the regulatory fog around this area of digital assets and whether they are securities.

• protects "information about convertible virtual currency transactions" from government collection unless the government obtains a search warrant. This is big for the many who have loudly protested that government backed stablecoins or CBDCs could lead to a huge erosion of privacy. (More on that here.)

This proposal is obviously in the very early stages of discussion, a discussion that will be informed heavily by the experience with $UST. Worth noting, though: although the proposal does not explicitly discuss algostables like $UST, it effectively prohibits them by requiring 1:1 reserves of M1 money, which algostables will never have. That's one thing that seems unlikely to change.

Both regulatory proposals essentially push issuers of stablecoins into the regulatory framework for banks. This makes sense from an incumbent regulatory perspective. Stablecoin issuers today look like banks in many ways: they take deposits and issue something that's redeemable on demand for dollars, in the same way banks do.

Regulators, however, are still trying to figure out how this fits in with the other functions of traditional banks: making loans and facilitating payments. So far they have concluded stablecoin issuers will not participate in making loans at all. You can see where they're coming from here. When stablecoins have accelerated from a supply of almost nothing in January 2020 to $171 billion today, it looks like a lot like a bank with an asset size comparable to the top 50 banks materialized out of thin air. With growth like that regulators are clearly worried about what a fully crypto-based bank, with the ability to make loans, would mean for the broader financial system and want to move slowly.

On the payments side, the regulatory proposals are basically silent. Stablecoin issuers have almost nothing to do with payments directly—blockchain transfers are designed to be peer-to-peer. But there will very likely be proposals to force stablecoin issuers to have the technological capacity to freeze/seize stablecoins in the name of anti-money laundering / terrorism financing, or criminal forfeiture. Where that discussion lands is anyone's guess; and whether that is in fact technologically feasible on what is supposed to be a decentralized system is beyond the scope of this article. Separately, neither legislative proposal touches on the PWG's idea of also regulating wallet providers.

In any event, it appears now that regulators are trying to push stablecoins and their issuers into traditional banking oversight. Just how that happens, and what compromises are made along the way, will likely involve fierce debate about the starting premises of the democratic proposal and the republican one. However, both sides so far agree on: (1) fully collateralized stablecoins; (2) no extra services like lending; (3) access to the federal reserve system; and (4) ongoing regulatory oversight for safety and soundness. Some version of those requirements is extremely likely to achieve enactment in the (near) future.

Originally published May 18, 2022.