Adi Ben-Ari is the Founder and CEO of data security specialist Applied Blockchain.
The collapse of TerraUSD and Luna in May, and the associated tailspin in the crypto market, have prompted observers from both within the decentralized finance (DeFi) space and externally to ask the now very serious question – what does the future hold?
Commentators, long-time sceptics and indeed some champions, point to regulatory safeguards for investor protection, balancing the benefits of DeFi with the protection of capital, greater efforts on managing stability in the market (a challenge without centralised financial institutions), and measures to ensure the wider financial market isn’t destabilised by future potential bubbles or crashes.
US Treasury Secretary Janet Yellen made her views clear, arguing that the trading of digital assets could present risks to the wider financial market, a view echoed more vociferously by the European Central Bank (ECB) Chief Christine Lagarde, who went further to state publicly that cryptocurrencies are essentially worthless.
This view has to be contested, yet there is a truth in the assumption that different types of cryptocurrencies represent different types of value.
Some are indeed worthless, while others represent underlying value for services, in particular the decentralised application and transaction hosting services (e.g., ETH for gas fees on Ethereum). In any case, both Lagarde and Yellen seem to agree that concerted and coordinated regulatory attention is needed.
It remains to be seen whether such doomsday predictions have truth in them. After all, the role of central bankers is intrinsically to maintain status quo and instill stability, somewhat at odds with the ethos of DeFi. But with inflation rates across the developed world reaching eye-watering levels, the prospect of another recession looming, an energy crisis driving up electricity costs, and the crypto market in retreat, we should be considering the immediate future and where, or how, cryptocurrencies will sit.
What happened with Terra?
Not since Bitcoin (BTC)’s inception and launch on the Genesis Block back in 2009 has the future looked less certain for DeFi. Back then, the world was still reeling from the turmoil of the 2008 Financial Crash, the colossal fall of Lehman Brothers, and the subsequent Great Recession, so the concept of a decentralised, citizen-owned digital asset outside of the control of banks seemed a Utopian ideal.
However, without any centralised authority to regulate the crypto market, by its nature it will get choppy, and even more so as it moves towards the mainstream, with the volume and value increasing. Terra, and its flagship product, the UST stablecoin and Luna, was supposed to act as a safe haven at these times, with investors able to transpose their more volatile digital assets, not into hard fiat currencies, which can be expensive, but trade them for stablecoins.
However, assets like UST muddy the waters further when it comes to regulation, as these decentralised USD-pegged stablecoins are uncollateralised and rely on algorithms to change the supply volume, rather than hard assets, to maintain the token’s price.
This makes applying regulatory uniform standards tricky.
The short selling and subsequent bear market of early May which prompted what was essentially a bank run and caused the Terra crash lays bare the fundamental flaw of this class of stablecoin. But this isn’t the first time Terra has de-pegged.
December 2020 saw Terra’s first de-peg, followed by another in January 2021, and then again in May 2021, but these were relatively short, and not widely publicised. They were, however, signs of things to come, highlighting potential faults in Terra’s design, as we highlighted in our risk analysis commissioned in January this year, several months before the crash. The major risk highlighted then, and which came to pass, was how tightly coupled the Anchor protocol was with Terra, the yield reserve of which was decreasing steadily, causing a drop in the annual percentage yield (APY) and a subsequent run on the token. This could and did lead to Terra de-pegging, with dire consequences for the stablecoin.
It is important to note that our report was based on public information and code that could have been inspected by any investor in Terra.
This is the beauty of decentralised and open blockchain technology. It is transparent and can only function in the way it was intended (coded).
However, if due diligence is not conducted by investors, and risks are not understood, then this type of situation could recur.
Investor protection – centralised regulations for decentralised finance?
From some investors’ perspective, the latest crash has been a disaster, with some losing their savings almost instantly, something long-term critics will now relish in evidencing the inherent risk of investing in digital assets with regulatory safeguards. It is true, the sector has been achingly slow in moving towards any form of a regulatory framework. The Financial Stability Board, a G20-funded affiliate of the Bank of International Settlements and coordinator of financial regulators across the world, has advised in its yearly report since 2020 that action was needed to regulate stablecoins, setting July 2022 as the deadline for frameworks to be set up in national jurisdictions of its members.
The Terra collapse has significantly accelerated this push for regulation, with the US, UK, and EU all promising swift action to bring stablecoins into a regulatory framework.
US Treasury Secretary Janet Yellen is pushing for legislation by the end of the year, while jurisdictions across the world will fast-track their central bank digital currency (CBDC) projects in order to provide a centralised and regulated alternative to stablecoins.
It is important to highlight, however, that the risks inherent in algorithmic stablecoins were known and pointed out long before recent events, and that a model backed by collateral assets presents a far more solid and secure solution.
Dismissing the innovative concept of a digital asset tied to an external reference, on the basis of one bad example that was clearly destined to finish like this if you looked closely at the way it was built, would be foolish and short-sighted.
Another aspect the Terra crash has highlighted is that the crypto market has generated enough resilience to withstand even a seismic event of this scale without truly losing investor confidence. Institutional funds increasingly focus their efforts and capital on digital assets, and the innovative technology underpinning crypto continues to revolutionise the way we transact. Terra’s collapse was an earthquake, of course, but the foundations built by blockchain technology continues to stand firm, essentially, because the potential of the underlying technology and the efficiencies that it can bring remain the same.