13 May 2022

Terra in the crypto markets

Turmoil caused by stablecoin's collapse will unsettle investors, generate disputes and flush out fraud, writes RPC’s Christopher Whitehouse


It has been a scary couple of days for holders of stablecoins.

Stablecoins are so named because they are designed to maintain a stable exchange rate with an underlying fiat currency such as the US dollar. They play a critical role in the cryptocurrency ecosystem, being used by cryptocurrency traders to facilitate transactions between different cryptocurrencies and transfer funds between crypto exchanges.

The fall of Terra

The turmoil in recent days began with the stablecoin Terra. Terra, an 'algorithmic stablecoin', was designed to have a symbiotic relationship with a linked support cryptocurrency called Luna. Investors theoretically could exchange one of Terra's tokens for 1 US dollars' worth of Luna or vice versa. The idea was that if Terra traded below 1 US dollar an investor could buy it and then exchange it for a US dollars' worth of Luna. This mechanic would drive demand for the Terra token back towards 1 US dollar. The reverse mechanic would pull it back to 1 US dollar if it exceeded that value.

Between 9 May 2022 and 11 May 2022 the value of Terra and Luna were virtually wiped out, the market capitalisation of the former falling from a height of approximately US$20bn immediately prior to the drop. The precise facts about what caused the decline are presently unknown, but reports suggest it was brought about by large outflows of Terra in the preceding days.

A run on USD Tether?

Fears of a possible contagion effect to other stablecoins peaked on 12 May 2022 at around 6:30 GMT when the value of USD Tether, the largest stablecoin by market capitalisation and intended to be pegged 1:1 to the US dollar, started dropping, falling to almost US$0.95 around 7:15 GMT before recovering.

Unlike Terra, USD Tether is said to be fully backed by tangible reserves. However, much of the details of those reserves are opaque. For example, a significant amount of Tether's reserves are commercial paper, the value of which would be linked to the creditworthiness of the unidentified companies issuing it. Furthermore, a portion of Tether's reserves are also stated to include unspecified digital tokens, which potentially exposes Tether to a form of indirect volatility risk. Given the opacity surrounding these reserves it is uncertain whether if there were a run on USD Tether they would be sufficient or if they could be liquidated sufficiently quickly to meet the incoming redemption requests.

If not, the impact on the cryptosystem would be significantly greater than the demise of Terra and the prices of cryptocurrencies would decline sharply. In this regard it is noteworthy that the value of Bitcoin and Ether as well as other cryptocurrencies fell at approximately the same time as Tether's dip before recovering, with the former dropping to its lowest level since its dramatic rise at the end of 2020.

The legal impact

From a legal perspective, sharp declines in the value of cryptoassets often give rise to disputes, for example around automatic liquidations of cryptoasset holders' positions. Such price declines have historically served to also flush out fraud when cryptoasset holders attempt to exit their positions and convert their holdings back into fiat currency.

In the specific case of investors in Terra and Luna, what legal recourse they may have, if any, will depend on what further facts emerge about what caused the currency pair to fail.

The future

While the immediate danger seems to have passed, USD Tether's temporary loss of its US dollar peg will leave a lasting impression and may leave cryptoasset holders feeling more nervous about future volatility than they were a week ago.

Christopher Whitehouse is a senior associate at RPC who advises on crypto-related disputes