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Financial markets and top US regulators have focused for the past few days on algorithmic stablecoin TerraUSD’s struggle to return to its $1 peg after it fell below 70 cents on Monday. Investors should be interested in the story, not what it says about crypto, but what it says about liquidity across all financial markets.
Most of the cryptocurrency coverage is about US dollar prices of crypto assets. It’s like trying to understand the US economy just by looking at the value of the dollar in the forex market. There is a massive crypto economy, backed by hundreds of billions of dollars of development effort, that provides services to end users on a daily basis. Your success depends on the value of those services and the new services that are made available to current and future users.
If you think of the crypto economy as a foreign land, markets for exchanging cryptocurrency for traditional currencies are like foreign exchange markets. Liquid foreign exchange markets can increase a country’s gross domestic product by facilitating international trade and investment. But they can also cause problems. Exchange rates are determined less by fundamental supply and demand from trade flows or purchasing power parity than by investor opinion and financial flows. Exchange rate volatility and unpredictable investment flows can disrupt the real economy. Because of this, most governments and central banks make lavish efforts to manage foreign exchange and foreign trade.
Although the crypto economy shows enormous promise at a fundamental level, efforts to establish liquid and stable financial transactions between traditional and crypto assets have been far from successful. Some cryptophiles think this is a good thing, preferring to shield the crypto economy from the regulations and problems of the traditional financial system. But other crypto enthusiasts are striving to connect traditional and crypto assets.
If TerraUSD fails, it won’t say anything about the fundamental value of crypto services, but it will be a blow to hopes that these services can be brought into the same financial system used for commodities 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 share in the profits of crypto ventures will have to spend those profits on crypto services.
More importantly, a failure of TerraUSD will deal a blow to the hopes of many traditional financial institutions that rely on liquidity to maintain stability. These include central banks, exchange-traded funds, mutual funds, derivatives clearinghouses, securities dealers, and many others. TerraUSD is an “algorithmic stablecoin,” meaning that it attempts to maintain a $1 market price via an algorithm, rather than traditional methods such as backing each individual coin token with a real dollar. TerraUSD can be exchanged for another $1 cryptocurrency, in this case Luna. Therefore, when the price of TerraUSD deviates from $1, arbitragers should push it back.
The Federal Reserve, while not officially targeting the value of the dollar, can use a similar strategy when trying to influence the value of the currency. When the value of the dollar falls, either in terms of purchasing power or exchange rates, the Fed’s main policy response is to raise interest rates to make the dollar more attractive, or to sell assets to absorb the dollar and strengthen the dollar reduce supply and drive up the price. TerraUSD mainly uses the second strategy of selling Luna to reduce the supply of TerraUSD.
The strategy relies on there being a liquid market for the asset to be sold – mainly US Treasuries for the Fed and Luna for TerraUSD. Unfortunately for the Fed, when the value of the dollar falls, investors may not be keen on buying Treasuries, which pay off in future dollars and whose perceived creditworthiness can be affected if too many have to be sold to absorb excess currency. TerraUSD has the same problem, Luna’s value is tied to the success of the Terra line of products which would be impacted by the collapse of TerraUSD.
ETFs face similar problems. Their price is designed to reflect the value of their underlying assets. When the ETF price deviates from the net asset value, arbitragers are supposed to drive it back by trading ETFs for their constituents or vice versa. But if either the ETFs themselves or their underlying assets lose liquidity, ETF prices can detach from their assets. Derivatives clearinghouses similarly rely on daily liquidity and limited price movements through their contracts. The London Metal Exchange discovered the dangers of this assumption in March, particularly in its nickel futures contract.
The mechanism used by TerraUSD is not central to the crypto economy. Many crypto entities are experimenting with this, but all for the purpose of exchange, not to provide basic services used by non-financial users. The traditional financial system, on the other hand, relies heavily on stabilization programs that require liquidity and are not as well designed or automated as TerraUSD. A TerraUSD failure should make you more concerned about your dollars, ETFs, and the traditional financial system than crypto. More from other authors at Bloomberg Opinion:
• Matt Levine’s Money Stuff: It’s not another algorithmic stablecoin
• 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 represent the opinion of the editors or of Bloomberg LP and its owners.
Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of The Poker Face of Wall Street. He may be involved in the areas he writes about.
For more stories like this, visit bloomberg.com/opinion
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