Algorithmic stablecoin collapse may crash crypto markets again, says IMF

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

Algorithms do not provide actual financial backing. In the end, there must be $1 worth of reserves redeemable for each stablecoin lest the issuer face a bank run-type situation. Many algorithmic stablecoins have failed when the public lost confidence and demanded to 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 $1 peg. TerraUSD (UST) exemplified the failure of algorithmic stablecoins when it collapsed in May despite promises from a once-$29 billion ecosystem to maintain a $1 price. UST holders quickly lost $14 billion in mark-to-market capitalization, plus untold billions from DeFi and other contracts tied to the price of UST, as it sold off to $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 ultimately failed in June 2021 in another bank run-type event, and IRON collapsed to $0.

Algorithmic stablecoins haven’t outgrown traditional stablecoins

Traditional stablecoins are backed by assets held by a central custodian — rather than whatever an algorithm can access — and are far larger. The backers of collateral-backed stablecoins, such as Paxos, Circle, or Tether, typically promise that customers can redeem their stablecoin for $1 at a corporate level.

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

These stablecoins come with the risk that their managers are lying or that they’ll suspend redemptions, making them similarly vulnerable to a bank run-type panic. For instance, 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 pose significant risks to investors. IMF Director Adrian warned that fiat-backed stablecoins could fail because they might not be backed 1:1 with cash.

For example, between February 19, 2019 and March 4, 2019, Tether edited its claim that it backed USDT purely by cash. It erased that promise and replaced it with a new pledge to back USDT with a basket of assets, including commercial paper. Nowadays, its latest version of that ever-shifting promise is to back USDT with various assets like gold, commodities, secured debt, bonds, and secured loans.

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

IMF views stablecoin risks as self-contained yet serious

Another recent IMF report echoed Tobias Adrian’s call for regulation. It stopped short of sounding an alarm, however, noting that the crypto industry does not currently pose contagion risks to broader economies.

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

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

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