Algorithmic stablecoin crash could send crypto markets crashing again, IMF says

The Director of Money and Capital Markets at the International Monetary Fund (IMF) has warned of further failures of stablecoins. In particular, director Tobias Adrian highlighted the risks of so-called algorithmic stablecoins, saying that “there are others that could fail.”

Algorithms do not provide real financial support. Ultimately, there must be $1 of redeemable reserves for each stablecoin, lest the issuer face a bank run-like situation. Many algorithmic stablecoins have failed when the public lost trust and demanded cash out, including TerraUSD, IRON, BasisCash, SafeCoin, BitUSD, CK USD, DigitalDollar, and NuBits.

Algorithmic stablecoins rely on assets in various wallets, smart contracts, and liquidity pools to defend a parity of $1. TerraUSD (UST) exemplified the failure of algorithmic stablecoins when it collapsed in May despite promises from a once $29 billion ecosystem to maintain a price of $1. UST holders quickly lost $14 billion in market capitalization, plus untold billions of DeFi and other contracts tied to the price of UST, as it sold for $0.

IRON, another algorithmic stablecoin similar to UST and promoted by Mark Cuban, suffered a similar fate. Titan Finance claimed to back IRON with its own token plus Circle’s USDC, but its $1 peg eventually failed in June 2021 in another bank-like event, and IRON crashed to $0.

Algorithmic stablecoins have not overtaken traditional stablecoins

Traditional stablecoins are backed by assets held by a central custodian – rather than anything an algorithm can access – and are much larger. Collateral-backed stablecoin backers, such as Paxos, Circle, or Tether, typically promise that customers can redeem their stablecoin for $1 at the enterprise level.

Because of this promise, these stablecoins typically trade in the $1 cent range. Examples of non-algorithmic asset-backed stablecoins are Tether (USDT), Binance USD (BUSD), Pax Dollar (USDP), and USD Coin (USDC).

These stablecoins carry the risk of their managers lying or suspending redemptions, making them equally vulnerable to a bank run-like panic. For example, Tether’s critics have accused it of failing to maintain adequate reserves or produce a financial audit. Tether dissolved its relationship with its first auditor, Friedman LLP, blaming Friedman’s “excruciatingly detailed procedures.”

Indeed, although algorithmic stablecoins are plagued with problems, traditional stablecoins also present significant risks to investors. IMF chief Adrian has warned that fiat-backed stablecoins could fail because they may not be backed 1:1 with cash.

For example, between February 19, 2019 and March 4, 2019, Tether changed its claim that it supported USDT cash-only. He erased that pledge and replaced it with a new pledge to back USDT with a basket of assets, including commercial paper. Nowadays, its latest version of this ever-evolving promise is to back USDT with various assets such as gold, commodities, secured debt, bonds, and secured loans.

The IMF continued to reiterate calls for crypto regulation.

Read more: ECB calls for stablecoin regulations to protect wider economy

IMF sees stablecoin risks as self-contained but serious

Another recent IMF report echoes Tobias Adrian’s call for regulation. However, he refrained from sounding the alarm, noting that the crypto industry does not present any contagion risks at this time to wider economies.

According to its report, the effects of this year’s crypto bear market have primarily impacted digital assets, businesses, and hedge funds. The report mentions a slowdown in advanced economies while heavily downplaying the impact of digital assets.

In summary, the multi-decabillion dollar collapse of the UST ecosystem was an unmistakable call for regulators to act. The IMF wants better regulation of stablecoins, focused on protecting investors. Its director admitted that regulating the more than 40,000 coins listed on CoinMarketCap poses a challenge. However, he advised regulating entry points such as stablecoin issuers and exchange owners as a first step.

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