TerraUSD’s Struggles Are a Concern for All Markets

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Financial markets and top US regulators have been focused on the struggle in recent days by the TerraUSD algorithmic stablecoin to return to its $1 peg after dropping to under 70 cents on Monday. Investors should care about the story, not for what it says about crypto but for what it says about liquidity in all financial markets.

Most of the coverage of cryptocurrency concerns the US-dollar prices of crypto assets. This is like trying to understand the US economy by looking only at the value of the dollar in the foreign-exchange market. There is an extensive crypto economy backed by hundreds of billions of dollars of development effort, which delivers services to end users every day. Its success depends on the value of those services, and the new services to be introduced to current and future users.

If you think of the crypto-economy as a foreign country, then markets to exchange cryptocurrency for traditional currencies are like foreign-exchange markets. Liquid foreign-exchange markets can boost a country’s gross domestic product by facilitating international trade and investment. But they can also cause problems. Foreign-exchange values are driven less by fundamental supply and demand from trade flows, or purchasing power parity, than by investor opinions and financial flows. Foreign-exchange volatility and erratic investment flows can be disruptive to real economies. For this reason, most governments and central banks make elaborate efforts to manage foreign-exchange and foreign trade.

Although the crypto-economy shows tremendous promise on a fundamental level, efforts to establish liquid and stable financial transactions between traditional and crypto assets have been less than successful. Some cryptophiles think this is a good thing, preferring to keep the crypto-economy insulated from the regulations and problems of the traditional financial system. But other crypto enthusiasts are anxious to connect traditional and crypto assets.

If TerraUSD fails, it will not say anything about the fundamental value of crypto services, but it will be a blow to hopes that those services can be brought into the same financial system used for goods and non-crypto services. Perhaps in the future people who want crypto services will have to earn crypto to buy them, and investors who want to participate in the profits of crypto ventures will have to spend those profits on crypto services.

Much more important, if TerraUSD fails it will be a blow to the hopes of many traditional financial institutions that rely on liquidity to maintain stability. That includes central banks, exchange-traded funds, mutual funds, derivatives clearinghouses, securities dealers and many others.TerraUSD is an “algorithmic stablecoin,” meaning it attempts to maintain a $1 market price via an algorithm rather than traditional methods such as backing each token with an actual dollar. TerraUSD can be exchanged for $1 worth of another cryptocurrency, in this case Luna. Therefore, if the price of TerraUSD deviates from $1, arbitragers should force it back.

The Federal Reserve, although it doesn’t officially target the value of the dollar, can use a similar strategy if it wants to influence the currency’s value. If the value of the dollar falls either in terms of purchasing power or foreign-exchange rates, the Fed’s two main policy responses are to raise interest rates to make the dollar more attractive to hold, or to sell assets to soak up dollars, reducing the supply, and pushing up the price. TerraUSD uses mainly the second strategy, selling Luna to reduce the supply of TerraUSD.

The strategy relies on there being a liquid market for the asset being sold — mainly US Treasury securities for the Fed and Luna for TerraUSD. Unfortunately for the Fed, if the dollar’s value is falling, investors may not be enthusiastic about buying Treasuries, which pay off in future dollars and whose perceived credit may be impaired if too many have to be sold to soak up excess currency. TerraUSD has the same issue, the value of Luna is tied to the success of the Terra suite of products, which would be impaired by TerraUSD’s collapse.

ETFs face similar issues. Their price is intended to reflect the value of their underlying assets. If the ETF price deviates from net asset value, arbitragers are supposed to drive it back by exchanging ETFs for their constituent assets, or the reverse. But if either the ETFs themselves or their underlying assets lose liquidity, ETF prices can untether from their assets. Derivatives clearinghouses similarly rely on daily liquidity and limited price moves by their contracts. The London Metals Exchange discovered the dangers of that assumption In March, particularly in their Nickel futures contract.

The mechanism used by TerraUSD is not central to the crypto-economy. Many crypto entities are experimenting with it, but all for the purposes of exchange, not for the production of fundamental services consumed by non-financial users. The traditional financial system, on the other hand, is heavily reliant on stabilization schemes that require liquidity, and are not as well designed or automated as TerraUSD. A failure of TerraUSD should cause you more worry about your dollars, ETFs and the traditional financial system than about crypto.More From Other Writers at Bloomberg Opinion:

• Matt Levine’s Money Stuff: Another Algorithmic Stablecoin Isn’t

• Bitcoin’s ‘Fire of Truth’ Gets a Bucket of Water: Lionel Laurent

• Does Your Country Really Need Digital Cash?: Andy Mukherjee

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is author of “The Poker Face of Wall Street.” He may have a stake in the areas he writes about.

More stories like this are available on bloomberg.com/opinion

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