The UST de-peg: would things have happened differently under MiCA?

It is no secret that on 9 May 2022, TerraUSD (UST) de-pegged from the US dollar and over the course of four days, collapsed, leading to the halt of the Terra blockchain ecosystem. In an attempt to save the project, the Luna Guard Foundation (LGF) liquidated a $3.2 billion reserve of Bitcoin and over $60 billion in market value has since evaporated.

In the aftermath of these events, the crypto industry is anticipating a global regulatory crackdown on algorithmic (and potentially all) stablecoins. At present, the regulatory approach to token issuance (stablecoins included) is still largely in development. Due to come into effect later this year, the European Union’s Markets in Crypto-Assets regulation (MiCA) will represent the first legislation of its kind to bring token and stablecoin issuers within its scope and may serve as a model for other jurisdictions looking to follow suit. How standard-setters and regulatory authorities approach stablecoins will be of vital importance to the industry, and the recent developments could very well change the course of that approach.

Algorithmic stablecoins

Before we delve deeper into MiCA, let’s acknowledge that algorithmic stablecoins are very different in nature from stablecoins backed by fiat currencies or even crypto-assets. While some have harkened the UST de-peg to a “bank run,” this is simply not the case as there were no external reserve assets backing future redemptions.

Terra’s algorithm was designed to preserve a peg to the US Dollar through the expansion and contraction of two opposing crypto-assets (LUNA and UST), a “perpetual motion machine” built to mitigate supply and demand and stabilised by nothing more than consumer confidence in the Terra ecosystem. As has been the case with other stablecoins, there is a trade-off between the innovation of the stabilisation mechanism, and the stability of the value itself. UST was no exception to this.

TerraUSD under MiCA

The EU’s forthcoming legislation denotes two categories of stablecoins that will be legally issued and traded by European Crypto-Asset Service Providers (CASPs); e-money tokens, which refer to a fiat currency that is legal tender, and asset-referenced tokens (ARTs), which refer to several currencies or any other value (fiat, crypto, commodities or a combination of such assets).

E-money and ART issuers will be required to create and maintain a reserve of assets that can only be invested in secure, low-risk instruments. Under MiCA, the LGF’s Bitcoin reserve would have been far too little, too late.

Issuers are also required to demonstrate a solid stabilisation mechanism. Unlike a law that allows for amendments based on environmental changes, an algorithm puts forth a deterministic solution that prohibits flexibility. Under MiCA, stabilisation mechanisms will have to prove flexible enough to absorb the shocks that are a reality in any market.

MiCA also imposes strict redemption rights for e-money and asset-referenced token holders, a requirement that Terra has been unable to honour, and prohibits the paying of interest to said holders. (Built on the Terra ecosystem, the Anchor protocol marketed a 20% yield to holders of UST).

Would MiCA categorise UST as an e-money token or an ART? If so, it appears that any issuer issuing UST in or from the EU would be unable to comply with the requirements.

As it stands, MiCA only references algorithmic stablecoins once in the recitals, clarifying that crypto-assets that “aim at maintaining a stable value, via protocols, that provide for the increase or decrease of the supply of such crypto-assets in response to changes in demand should not be considered as asset-referenced tokens, provided that they do not aim at stabilising their value by referencing one or several other assets.” This statement proves challenging given that algorithmic stablecoins tend to reference one or several currencies.

If an algorithmic stablecoin does not reference one or several currencies and is considered to be a regular crypto-asset, it will have to comply with regular issuance requirements, including establishing a legal presence in the EU, disclosure requirements in the form of a whitepaper, and other requirements regarding marketing. One could argue that holders of UST would have been much better informed and protected in a MiCA world, although that may not have been enough to prevent the collapse.

Key policy and regulatory areas of focus going forward

MiCA aside, there are some likely areas of focus going forward with regards to stablecoins, and especially where algorithmic stablecoins are concerned. We can expect regulators to scrutinise:

• the quality, composition, and volume of reserve assets, if any, and a threshold to limit how much of those assets can be invested;
• a full disclosure of the stabilisation mechanism used;
• the ability for stablecoin ‘pegs’ to respond under stress; and
• risk warnings to consumers, particularly when dealing with algorithmic stablecoins.

Although policy decisions should be proportionate, many policymakers and regulators are likely to respond aggressively towards stablecoins given the collapse of UST.

Conclusion

The failure of the Terra ecosystem calls us to take note of the EU’s regulatory approach, an approach that may act as a guide for jurisdictions implementing similar frameworks in the near future. At its heart, regulation is about consumer protection. Would MiCA have protected consumers from the economic fallout of the UST de-peg? To start with, if Terra had been categorised as an e-money token or ART, it would not have met baseline requirements to be issued in the EU. On the other hand, if categorised as a crypto-asset, there would have certainly been enhanced consumer protection measures at play.