The Next Stablecoin Collapse Could Be a Lot Worse

(Bloomberg Opinion) -- Thanks to the spectacular demise of TerraUSD, a cryptocurrency that promised to be always worth a dollar but was suddenly worth a lot less, the world is better acquainted with the term “stablecoin” — and aware of how unstable they can be.

Luckily, the collapse hasn't had serious repercussions in the traditional financial system. If the US doesn't act soon to regulate these things, the next one could.

Stablecoins arose primarily to facilitate speculation. People needed a haven where they could park funds between bets on wildly volatile crypto, so issuers created digital tokens tied to the very same government-issued currencies — typically the US dollar — that crypto was supposed to disrupt. Total issuance stood at more than $160 billion in late May, up more than 10 times in just two years.

Gambling aside, the technology does have potential. Stablecoins move on computer networks that cross national borders, so in theory they could make international transactions faster and cheaper — possibly saving migrant workers, for example, billions of dollars in fees on remittances to families back home. Because they don't rely on crisis-prone banks to process payments, they could make the financial system more resilient. Eventually, they might even provide the infrastructure for government-issued digital currencies.

Unfortunately, as TerraUSD demonstrated, stablecoins aren't yet reliable. Some claim to hold enough “reserves” to redeem each token for an actual dollar, but guard the details or invest in risky assets — as illustrated by the largest stablecoin, Tether. Others, such as so-called algorithmic stablecoins, seem conjured out of thin air. TerraUSD was supposed to be redeemable for a dollar's worth of another cryptocurrency, Luna, until the value of both plummeted in an entirely foreseeable “death spiral.”

This might not matter if it didn't threaten innocent bystanders, but it does. The bigger the crypto world gets, and the more connections it forms with traditional finance, the greater the chances that a stablecoin crash will cause broader damage.

Consider the commercial paper market, where ordinary companies borrow money for purposes such as payroll and inventories — and where Tether claims to invest about $16 billion of its reserves. If stablecoin issuers became large enough, and if doubts about their dollar pegs triggered a rush for the exit — a possibility Tether recently previewed — the flight of funds could cut the real economy's access to short-term credit. In 2008, a run on money-market mutual funds crippled the commercial paper market, and helped turn a bad recession into the worst since the Great Depression.

Unregulated stablecoin issuers are prone to create such systemic risks. The solution is to recognize that they are, in effect, special-purpose banks providing payment services, and regulate them accordingly. This means strict limits on their investments, up to and including requiring deposits at the Federal Reserve, so that anything claiming to be worth a dollar would be backed by one. Capital requirements and other rules are also needed to protect against hacks, crime and abuse.

There's no mystery about what needs to happen. The Treasury Department issued a report last year detailing the steps that Congress and federal agencies ought to take. Lawmakers are trying to build bipartisan support for the changes. All that remains is to get the job done — preferably before stablecoins trigger the next financial crisis.