Why has the Terra stablecoin broken its US dollar peg and should you care?

TerraUSD's algorithm is supposed to keep it pegged to the US dollar by adjusting supply via a sister token, luna

(Image credit: © Vladyslav Yushynov / Alamy)

published 10 May 2022

A beginner’s guide to bitcoin: what is bitcoin?

In his book on the 1929 stockmarket crash, economist John Kenneth Galbraith talked about the “bezzle”. This was the inventory of as-yet-undiscovered fraud which led to the false impression that everyone was wealthier than they really were.

Warren Buffett’s colleague Charlie Munger extended this notion to include more generic bubble thinking – stuff that isn’t out-and-out fraudulent, more just a reflection of the nonsense that people come to believe in during boom and bubble times.

The overall impact of the bezzle is that it results in a period where, like Wile E Coyote in the Road Runner cartoons, investors are running on thin air, thinking that it’s still solid ground.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Then they look down.

How Terra broke its US dollar peg

I’ve been reminded of this notion of the bezzle because something really rattled the horses in the cryptocurrency sphere yesterday.

It’s all about stablecoins, and one that has turned out to be not-so-stable.

A stablecoin is a type of cryptocurrency which is “pegged” to another asset –usually the US dollar. The point is to offer a form of crypto whose value can be relied upon. So you get the benefits of crypto, such as they are, but combined with a stable (or at least predictable) value.

In practice, stablecoins are often used as places for crypto investors to park their money on trading platforms, rather than having to go through the rigmarole of turning their cryptocurrency back into fiat currency. They sit in stablecoins instead.

You may already be starting to observe a certain circularity here. I am by no means the most sceptical person out there on cryptocurrencies, but one issue I’ve always had is with how tricky it is to get in and out of crypto. Put simply, I don’t really trust the infrastructure.

Yes, that’s partly down to my lack of knowledge of the underlying mechanics. But it’s also because I’ve seen what happens in bear markets and I know that during bear markets, the things you take for granted (like being able to move your money from one place to another easily) evaporate and sometimes break altogether.

I like to know that I can get both into and out of an investment easily, or at least what barriers to exit there might be in tough times. I’m not yet confident of that in crypto.

Anyway. One particular stablecoin, TerraUSD (ticker UST), the third-largest in the sector, has run into trouble.

TerraUSD was unusual in that it was backed not by actual US dollars, but by an algorithm. The algorithm would adjust the supply of TerraUSD in order to keep its value pegged to that of the US dollar. It did this via a sister token, “luna”.

I would be lying if I told you I understood how this works, but put very simply, if the price of TerraUSD rose above $1, the net effect would be to create more of the coins, driving the price back down. If it fell below, some coins would be removed from circulation.

It’s a lot more complicated and clever than that, I’m sure. But it can’t be that clever, because yesterday TerraUSD burst its peg to the dollar and fell as low as 60-odd cents.

In some ways, cryptocurrency seems hellbent on making exactly the same mistakes as traditional finance, only with a digital overlay of pseudo-complexity.

The problem with currency pegs – as financial history has shown time and time again – is that they are very hard to maintain when times get turbulent. British readers may well remember the UK’s own experience of trying to maintain a currency peg, which saw sterling kicked out of the European Exchange Rate Mechanism (ERM) in the early 1990s, amid panicky increases in the Bank of England base rate.

Don’t invest in anything you don’t understand

Anyway, it’s all very interesting from a curiosity point of view. But how significant is this for broader markets?

The good news is that the cryptocurrency world is not important enough or big enough to pose a systemic risk as yet. The bad news is that it’s just more evidence that the days of nonsense are now behind us and assets which relied entirely on more forgiving times are now going to be found wanting.

It’ll be interesting to see what happens to the other big stablecoins, for example. These are meant to be backed one-to-one by actual US dollars or other collateral. If that’s indeed the case, they should be able to survive any rush to redeem. I’m sure we’ll find out before long.

Another point I’d make is that a lot of oddly convenient stuff happens in the crypto area when crashes come along. I’m talking about stuff that looks to me like the functional equivalent in equities of big fund platforms suddenly declaring that they couldn’t process any sell orders during a market crash.

All of that aside, the lesson – once again – for investors is: don’t invest in anything you don’t understand. And if you have, it’s not too late.

Review your portfolio if you haven’t already. The dodgy stuff that you hoped would come good? If it didn’t in the easy times, it’s not going to now. Unless you think you have a genuinely good reason to ignore this admittedly sweeping statement, I’d say it’s time to cut your losses and hang onto the cash for better opportunities. They are sure to come.

Explore More

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.