Not So Stable: Stablecoin Volatility Causing Turmoil in Crypto Markets

Key Takeaways

• Volatility in the market for so-called stablecoins has led to recent litigation against a stablecoin issuer and Coinbase, the popular cryptocurrency trading platform. That case reflects a broader trend of private investors bringing crypto-based litigation in the United States.
• The collapse of stablecoin TerraUSD sent ripple effects through cryptocurrency markets earlier this month and raises important questions about potential legal challenges and future regulation of stablecoins.

Introduction

Cryptocurrencies have surged in popularity in recent years. As we have reported in recent OnPoints, the swift growth and adoption of cryptocurrencies raise legal questions about everything from their regulatory status, to their taxability, and how to define them. Recent volatility in the stablecoin market, and the collapse of stablecoin TerraUSD (“Terra”), raise additional questions concerning the development of cryptocurrency products and the impact of litigation risk.

Earlier this month, Terra, the largest algorithmic stablecoin by market capitalization, collapsed. Ostensibly pegged to the United States dollar, Terra’s value precipitously declined from US$1 to US$0.10. Around the same time, private investors brought a putative class action against stablecoin issuer GMO Trust and Coinbase, the popular cryptocurrency trading platform, for their alleged involvement in deceptively marketing a volatile stablecoin called GYEN. The investors claim that Coinbase caused them to lose millions when it froze trading of GYEN amidst the turmoil. This unrest in the stablecoin market has had ripple effects throughout the broader crypto market.

Not surprisingly, the explosive growth of cryptocurrencies has brought with it a dramatic increase in crypto-based litigation, which has increased more than 50 percent since the start of 2020. And while federal lawmakers and regulators have expressed eagerness to issue rules governing stablecoins, private plaintiffs have sought to fill in the gaps. Although it is unclear whether Congress will be able to adopt comprehensive legislation, it is clear that legislators on both sides of the aisle recognize the desirability of additional regulation of stablecoins.

Background

Stablecoins, like other crypto products, have exploded in popularity. Earlier this month, stablecoins’ overall market capitalization totaled about US$180 billion.¹ Although that accounts for just 5 percent of all crypto assets, at one point last year “more than 75 percent of trading on all crypto trading platforms” involved a stablecoin.² But stablecoins differ from other cryptocurrency products, like Bitcoin, in that they are designed to have their value pegged to the value of a government-issued (or “fiat”) currency, like the U.S. dollar,³ or a physical asset, such as gold, on a one-to-one basis where the value of the digital asset is intended to equal the value of the reference asset (e.g., one dollar, one gram of gold). When functioning properly, a stablecoin pegged to the U.S. dollar will consistently be worth one U.S. dollar.

There are two types of stablecoins: asset-backed and algorithmic. Asset-backed stablecoins maintain their value by holding sufficient reserves, such as cash and short-term government securities, to back up their tokens.⁴ The most popular stablecoins, like Tether and USD Coin, are reportedly asset-backed on a one-for-one basis (e.g., one dollar or dollar-equivalent backing one dollar in an outstanding digital asset). Other asset-backed stablecoins, such as Dai, are backed by overcollateralized (rather than one for one) digital assets. Tether, the largest stablecoin by market value, “is backed by both safe investments, such as cash and short-term U.S. government securities, and riskier ones, including short-term IOUs known as commercial paper, secured loans to companies, and other cryptocurrencies.”⁵ By contrast, algorithmic stablecoins are not backed by reserves; they rely on complex “financial engineering” to maintain a steady value linked to a fiat currency.⁶ Before its collapse, Terra was the most popular algorithmic stablecoin with a market capitalization of about US$20 billion.⁷ It preserved its peg to the U.S. dollar by use of Luna, a linked cryptocurrency.⁸ Ostensibly, investors “could exchange one of Terra’s tokens for 1 US dollars’ worth of Luna or vice versa.”⁹ So in theory, as Terra falls below its US$1 peg, traders may exchange it for US$1 worth of Luna. When this exchange occurs, Terra tokens are removed from circulation, reducing its supply and raising its price.¹⁰ Thus, the idea was that as the price of Terra or Luna fluctuated, traders would use the other currency to preserve an equilibrium, thus holding Terra’s value at US$1.

Crypto traders favor stablecoins over fiat currencies to facilitate cryptocurrency transactions because they can allow them to avoid long settlement times associated with fiat currencies.¹¹ And some investors prefer to store cash in stablecoins because they can use stablecoins to easily transfer funds between crypto exchanges¹² and earn interest on their stablecoins by depositing them with crypto-based financial institutions, like BlockFi.¹³

Stablecoins, and the platforms on which they trade, have recently come under intense scrutiny. The federal government’s interest in legislating and regulating cryptocurrency, and stablecoins specifically, continues to grow.¹⁴ And while regulatory enforcement actions against cryptocurrency companies and platforms are hardly new, a surge in private litigation presents new challenges.¹⁵

TerraUSD and Luna Send Ripples Through Crypto Markets

The Creation and Collapse of Terra and Luna. Terra launched in 2020, amassing a market capitalization of nearly US$20 billion before its collapse.¹⁶ Exchanges between Terra and Luna are central to Terra maintaining its US$1 price, yet that system broke down earlier this month. Beginning around May 7, Terra broke from its peg and began losing value.¹⁷ As Terra fell below US$1, investors rapidly sold Luna, causing the linked cryptocurrencies to nosedive.¹⁸ Terra dropped to a low of US$0.08, briefly rallied to US$0.31, and is now valued at just US$0.0687.¹⁹ Terra’s market value has fallen from its nearly US$20 billion high²⁰ to about US$773 million.²¹ Luna has also plummeted, currently trading at US$0.0001591, down from a high of nearly US$100 in April.²² Its market value has fallen to about US$1 billion, down from about US$41 billion earlier this year.²³ One analytics firm estimates that holders of Terra and Luna lost about US$42 billion from May 9 to May 16.²⁴

The broader crypto market felt the aftershocks of Terra’s collapse. All told, crypto investors lost “more than US$240 billion of wealth in a single day” as a result of Terra’s decline,²⁵ and current losses stand around US$300 billion “across the crypto economy.”²⁶ This market uncertainty hit Bitcoin particularly hard, driving its price below US$26,000 for the first time since December of 2020.²⁷ Other stablecoins also felt the effects of Terra’s swift decline. For example, the industry’s largest stablecoin, asset-backed Tether, saw its market capitalization decline from an all-time high of US$83 billion on May 11 to US$75.6 billion on May 17 as it briefly lost its dollar peg.²⁸

The Attempt to Revive Terra and Luna. Terra’s creator, South Korean entrepreneur Do Kwon, announced a plan on May 16 to attempt to revive Terra.²⁹ He plans to do “what is called a ‘fork’ in software terms—basically taking the existing code and starting over with an updated version.”³⁰ The updated version would eliminate the algorithmic stablecoin and “distribute 1 billion tokens of a new version of Luna to existing Luna and Terra[] holders and developers.”³¹

Kwon unsuccessfully tried to save Terra last week during its slide, as well. Although an algorithmic stablecoin, Terra did have some reserves meant to protect it from this type of collapse. Specifically, the Luna Foundation Guard (“LFG”), a non-profit Kwon co-founded to support Terra, holds substantial Bitcoin reserves, which as of May 7, totaled about US$3.5 billion.³² But even though Terra was purportedly backed by these reserves, Terra’s value still plunged.³³

Volatility in the Stablecoin Market Expands Beyond Terra

Terra’s collapse is just the most recent example of extreme volatility in the stablecoin market. Last fall, GYEN, an asset-backed stablecoin pegged to the Japanese yen, caused turmoil when it became untethered from the yen and spiked in value.³⁴ GYEN was listed for trading on Coinbase on November 10, 2021.³⁵ One week later, GYEN broke free from its peg, increasing to about 7.5 times the value of the yen before falling back to the peg.³⁶ Coinbase eventually disabled trading for “technical reasons” after a flurry of trading activity.³⁷

Last week, private investors sued GMO Trust (the issuer of GYEN) and Coinbase on behalf of themselves and a purported class.³⁸ The proposed class action complaint accuses GMO Trust and Coinbase of misleading investors about GYEN. Specifically, the complaint alleges the defendants knew, “based on a prior destabilizing event, that GYEN’s peg to the yen was prone to break and that such an event would be likely, if not certain, when GYEN opened for trading on Coinbase.”³⁹ Plaintiffs further claim that Coinbase “compounded the harm by restricting many customers’ ability to sell the asset,” causing the loss of “untold millions in a matter of hours.”⁴⁰

The proposed class action complaint advances numerous potential liability theories against GMO Trust and Coinbase, including consumer class action claims under California law and alleged violations of the Securities Act of 1933. Plaintiffs claim that Coinbase, as a trading platform, had itself marketed the cryptocurrencies available for trading. GYEN, however, has not previously been viewed as a security by the Securities and Exchange Commission or any court, and therefore, we think it unlikely that the securities claims will survive a motion to dismiss.

Looking Ahead

Litigation. The suit against GMO Trust and Coinbase is just the tip of the iceberg. According to Morrison Cohen’s Cryptocurrency Litigation and Regulation Tracker, “[c]rypto has generated more than 200 class action lawsuits and other private litigation as of this month, up more than 50% since the start of 2020.”⁴¹ The Cryptocurrency Litigation and Regulation Tracker further shows that class actions and private suits make up half of all crypto litigation.⁴² Given these metrics, it seems likely that the Terra and Luna collapse will invite its own deluge of legal claims. But clarity as to what recourse investors may have, if any, will likely have to wait for a greater understanding of the events that precipitated the collapse.⁴³ And whether courts will accept plaintiffs’ theories of liability or efforts to litigate these cases as class actions remain open questions that will likely depend on the individualized facts of each case. Despite much uncertainty, one thing seems clear: the flood of crypto litigation will continue.

Federal Regulation and Legislation. The U.S. Senate Committee on Banking, Housing, and Urban Affairs held a hearing on May 10 during which Treasury Secretary Janet Yellen called for increased regulation of stablecoins in the United States.⁴⁴ In doing so, she acknowledged Terra’s decline, saying it “simply illustrates that this is a rapidly growing product and there are risks to financial stability. We need a framework that’s appropriate.”⁴⁵

At the May 10 hearing, Banking Committee Chairman Sherrod Brown (D-Oh.) said the stablecoin’s failure “underscores the seriousness of its threat to the financial system, because it’s unregulated. . . . [T]here’s just too many examples in the cryptocurrency world of that potential.”⁴⁶ Senator Pat Toomey (R-Pa.), the Ranking Member, seemingly agreed with the problem and expressed interest in moving quickly on legislation establishing a regulatory framework for stablecoins.⁴⁷ Yet it remains to be seen whether Senators can agree on what to regulate and how. Senator Toomey disputed the notion that Terra’s collapse would require broader stablecoin regulation and instead expressed support for regulations targeting those stablecoins that are likely to pose a greater systemic risk.⁴⁸

Meanwhile, in the House of Representatives, a bipartisan group has re-introduced the Digital Commodity Exchange Act.⁴⁹ The bill, which is an updated version of a similar bill introduced in 2020, seeks to extend the authority of the Commodity Futures Trading Commission to regulate cryptocurrencies, including stablecoins, and their issuers.⁵⁰ Notably, the bill seeks to ensure that stablecoin issuers have enough assets on hand to redeem stablecoins for fiat currency.⁵¹

In the event that Congress can’t agree on a regulatory framework for stablecoins, Democrats have proposed that the Executive Branch, through the Securities and Exchange Commission, the Federal Reserve, and the Federal Deposit Insurance Corporation, take the regulatory measures that they believe would be necessary to protect consumers.

Footnotes

1. Caitlin Ostroff, Why Did Cryptocurrencies TerraUSD and Luna Unravel? Stablecoin Price Crash Explained, WALL STREET JOURNAL (May 13, 2022).
2. Chair Gary Gensler’s Statement on the President’s Working Group Report on Stablecoins, United States Securities and Exchange Commission (Nov. 1, 2021).
3. Why Did Cryptocurrencies TerraUSD and Luna Unravel? Stablecoin Price Crash Explained, supra note 1.
4. Why Did Cryptocurrencies TerraUSD and Luna Unravel? Stablecoin Price Crash Explained, supra note 1.
5. Id.
6. Id.
7. Christopher Whitehouse, Terra in the crypto markets, THE GLOBAL LEGAL POST (May 13, 2022).
8. Id.
9. Id.
10. Why Did Cryptocurrencies TerraUSD and Luna Unravel? Stablecoin Price Crash Explained, supra note 1.
11. Id.
12. Terra in the crypto markets, supra note 7.
13. See Regulatory Developments, BlockFi.
14. Caitlin Reilly & Sarah Wynn, Terra’s stablecoin flop raises questions about regulatory role, ROLL CALL (May 17, 2022).
15. Sam Skolnik, Crypto Lawsuit Deluge Has Big Firms Scrambling to Keep Up, BLOOMBERG LAW (May 17, 2022).
16. Why Did Cryptocurrencies TerraUSD and Luna Unravel? Stablecoin Price Crash Explained, supra note 1.
17. Id.
18. Ryan Browne, $3 billion in bitcoin was sold in a last-ditch attempt to save UST stablecoin from collapse, CNBC CRYPTO WORLD (May 16, 2022).
19. TerraUSD, CoinMarketCap, available at https://coinmarketcap.com/currencies/terrausd/ (last accessed May 24, 2022, 4:15 p.m. ET).
20. Paul Vigna, Cryptocurrency TerraUSD Falls to 11 Cents, Creator Announces Rescue Plan, WALL STREET JOURNAL (May 16, 2022).
21. TerraUSD, supra note 19.
22. Terra, CoinMarketCap, available at https://coinmarketcap.com/currencies/terra-luna/ (last accessed May 24, 2022, 4:20 p.m. ET).
23. Cryptocurrency TerraUSD Falls to 11 Cents, Creator Announces Rescue Plan, supra note 20.
24. $3 billion in bitcoin was sold in a last-ditch attempt to save UST stablecoin from collapse, supra note 18.
25. Id.
26. David Yaffe-Bellany & Erin Griffith, How a Trash-Talking Crypto Founder Caused a $40 Billion Crash, NEW YORK TIMES (May 18, 2022).
27. $3 billion in bitcoin was sold in a last-ditch attempt to save UST stablecoin from collapse, supra note 18.
28. Andrew Asmakov, Tether Supply Plummeted $7.4B Amid Depegging Concerns, Terra Collapse, Decrypt (May 17, 2022).
29. Terra Ecosystem Revival Plan 2, Terra (last accessed May 18, 2022).
30. Cryptocurrency TerraUSD Falls to 11 Cents, Creator Announces Rescue Plan, supra note 20.
31. Id.
32. Cryptocurrency TerraUSD Falls to 11 Cents, Creator Announces Rescue Plan, supra note 20.
33. See id.
34. Scott Zamost & Eamon Javers, Coinbase customers demand refunds over GYEN stablecoin glitch, CNBC (Dec. 8, 2021).
35. Id.
36. Id.
37. Id.
38. Complaint, Donovan, et al. v. GMO-Z.com Trust Co., Inc., et al., No. 22-cv-2826 (N.D. Cal. May 12, 2022).
39. Id. at ¶ 5.
40. Id. at ¶¶ 7, 9.
41. Crypto Lawsuit Deluge Has Big Firms Scrambling to Keep Up, supra note 15 (citing Cryptocurrency Litigation and Regulation Tracker, Morrison Cohen LLP).
42. Id.
43. Terra in the crypto markets, supra note 7.
44. Testimony of Secretary of the Treasury Janet L. Yellen before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, U.S. Department of the Treasury (May 10, 2022).
45. Terra’s stablecoin flop raises questions about regulatory role, supra note 14.
46. Id.
47. Opening Statement of Ranking Member Pat Toomey (R-Pa.), U.S. Senate Committee on Banking, Housing, and Urban Affairs (May 10, 2022).
48. Terra’s stablecoin flop raises questions about regulatory role, supra note 14.
49. Digital Commodity Exchange Act of 2022, H.R. 7614, 117th Cong. (2022)
50. Id.
51. Id.