A dictionary page with the word stablecoin highlighted.

Collateral damage: The collapse of TerraUSD underscored the vulnerability of stablecoins lacking sufficient collateral

“Confidence in money is fundamental to UK financial and economic stability,” noted Andrew Bailey, Governor of the Bank of England, as he launched a recent consultation on the future regulation of stablecoins and systemic payment systems.

The consultation marked nearly 10 years since Tether was launched as the first stablecoin in 2014.

Stablecoins peg to a national currency, typically the US dollar, and are used to transact in non-stable crypto assets more efficiently than using national currencies.

They operate on decentralised networks called blockchains, a public distributed ledger of transactions which are verified and recorded without needing a central authority to approve them.

Stablecoins like Tether purport to offer a stable store of value, but recent events, such as the collapse of stablecoin TerraUSD in May 2022, have underscored the vulnerabilities in stablecoins lacking sufficient collateral.

So how do we maintain stability and bolster confidence in these digital assets? 

In my research, I outline the key principles of stablecoin design, and advocate for measures such as decentralised arbitrage, full collateralisation with stable reserves and robust regulatory oversight. These are principles stablecoin issuers should follow to maximise efficiency and stability.

Decentralised arbitrage makes stablecoins markets more efficient

In a collaborative research effort with Richard Lyons, of UC Berkeley, we explore how arbitrage plays a crucial role in maintaining the stablecoin price at its pegged rate

In the context of stablecoins, arbitrage is the practice of exploiting price differences between the stablecoin primary and secondary markets.

The primary market is where stablecoins are minted and redeemed at an exchange rate of one US dollar to one stablecoin. The secondary market refers to trading of stablecoins on cryptocurrency exchanges and is where prices can fluctuate and trade at a discount or premium to one US dollar.  

To illustrate, let us consider a case when the stablecoin price trades above one dollar in the secondary market. Investors can make a profit by depositing one dollar with the issuer in the primary market, receive one stablecoin, and subsequently sell the stablecoin in the secondary market. The arbitrage increases circulating supply, putting downward pressure on stablecoin market price toward parity.

Conversely, consider the stablecoin trading at a discount. An investor can make a profit by purchasing the stablecoin cheaply in the secondary market and redeeming the stablecoin in the primary market to obtain one dollar.

We argue that facilitating decentralised access to arbitrage opportunities enhances market efficiency. Easy access to conduct arbitrage trades in the primary market, through access to a deposit and redemption process with the stablecoin issuer, and readily available arbitrage capital, are necessary conditions for a stable peg.

Why was Tether migrated to the Ethereum blockchain?

Drawing on real-world examples, such as the transition of stablecoin Tether from the Omni to Ethereum blockchain in April 2019, we highlight the impact of blockchain efficiency on access to arbitrage trades in the primary market.

The decision to migrate Tether to the Ethereum blockchain was influenced by Ethereum’s larger community of investors and its efficiency in processing transactions. By studying the movement of Tether from the Treasury to private investors, we assessed how the migration affected investors’ ability to conduct arbitrage.

Our findings suggest the migration of Tether to the Ethereum blockchain played a crucial role in increasing access to arbitrage trades. Following the migration, there was a significant increase in the number of unique addresses interacting with the Tether Treasury on the Ethereum blockchain compared to Omni. 

After the migration, there was a notable decrease in the size of deviations from Tether’s pegged price, by approximately 50 per cent, accompanied by a reduction in the time it took to correct these deviations, from six to three days.

The observed effects are consistent with our hypothesis that increasing access to arbitrage trades is key to stablecoin stability.

Why stablecoins require safe collateral

In addition to decentralised arbitrage, it is important for the stablecoin to be backed by liquid, safe collateral.

To shed light on this principle, in collaboration with my WBS colleague, Roman Kozhan, Professor of Finance, we investigated  DAI, a decentralised stablecoin that enables an individual user to deposit various types of collateral, for example Ethereum (ETH), a risky cryptocurrency, to issue new DAI tokens.

Initially, DAI could only be issued through risky ETH collateral. An implication of this design is DAI price fluctuations correlate with returns and volatility of the ETH collateral.

In response to extreme fluctuations of the DAI stablecoin in March 2020, the governance body MakerDAO started allowing users to deposit safe collateral types, such as stablecoin USDC issued by Circle. Additionally, in December 2020, MakerDAO introduced a peg stability module (PSM), so users can exchange one USDC for one DAI with the MakerDAO treasury.

The PSM therefore facilitates an arbitrage mechanism to keep the DAI price stable. When the DAI trades at a premium relative to USDC, a user can swap USDC for DAI tokens with the MakerDAO treasury and sell DAI in the secondary market to make a profit, bringing the DAI price closer to parity.

Our findings suggest that introducing safe collateral types makes it easier for arbitrageurs to execute price-stabilising trades. After the introduction of PSM in December 2020, we found a notable decrease in the size of deviations from DAI’s pegged price of up to 50 basis points.

How should stablecoins be regulated?

Our insights point to clear recommendations for regulating stablecoins.

One of the fundamental principles we advocate for is the full backing of stablecoins with collateral in the form of liquid dollar reserves.

This ensures a smooth functioning of the arbitrage mechanism that helps a stablecoin maintain its pegged value, even in times of market turbulence or speculative attacks.

One potential solution to mitigate stablecoin devaluation risks is the implementation of real-time audits utilising a proof-of-reserve system. This means having independent verification of the assets backing the stablecoin at regular intervals, reducing the likelihood of runs and mitigating the risk of issuers absconding with funds. Such measures would enhance transparency and bolster investor confidence in the stability and reliability of stablecoins.

Looking ahead, there are opportunities for the growth of stablecoins in foreign exchange (FX) trading.

In ongoing research we are investigating how stablecoins pegged to the euro and US dollar are connected to trading in traditional markets. By demonstrating their efficacy in FX trading, stablecoins could unlock new avenues for cross-border trading, remittances, and the global financial architecture.

Further reading:

How should governments regulate stablecoins and cryptocurrency

How banks may use stablecoins as a route to CBDCs

What keeps stablecoins stable? 

Decentralized stablecoins and collateral risk

Ganesh Viswanath Natraj is Assistant Professor of Finance at Warwick Business School and a researcher at the Gillmore Centre for Financial Technology. He teaches Digital Currencies and Decentralised Finance on MSc Finance and MSc Finance and Business.


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