What Terra's Meltdown Means for Centralized Stablecoins Tether and USDC

As the market panics over the implications of Terra’s UST losing its dollar peg, questions have been raised about its asset-backed stablecoin competitors, Tether and USD Coin. 

Tether (USDT) and USD Coin (USDC)—the two largest stablecoins by market cap, respectively—are backed by the U.S. dollar, meaning that the issuers of these coins ostensibly maintain reserves of cash or cash equivalents to back each coin that’s in circulation. 

The idea being that if an investor decided to redeem their USDT or USDC, they would get exactly $1 back for every token that the stablecoin issuer sold.

Meanwhile, UST is an algorithmic stablecoin that uses a smart contract (essentially just computer code that determines when the reserve needs to be topped up) to maintain its 1:1 dollar peg, and recently began keeping the majority of its reserve in Bitcoin, thanks to the Luna Foundation Guard. But given the amount of volatility in the market, at one point yesterday UST’s price hit an all-time low of $0.6841, losing its peg with the dollar.

Even though its tokenomics are completely different, there’s been some concern that Terra’s troubles could cast doubt on other stablecoins. But Tether co-founder Reeve Collins said there’s no need to panic.

“Tether holders should feel very secure that Tether will hold its peg since it is dollar backed and market forces do not affect it,” Collins told Decrypt in an email. “I wouldn't be surprised to see an increase in holders of algorithmic stablecoins start to move their money into asset backed coins like Tether."

A spokesperson for Circle, the company behind USDC, told Decrypt that the stablecoin "is conservatively backed by cash and short-term U.S. government obligations, making it easily redeemable and stable for transactions."

Asset-backed stablecoins have been without their own problems. On a few occasions, Tether and USDC have lost their dollar pegs.

Most recently, USDT dropped to $0.98 on March 16, 2020, as crypto and traditional markets reacted to news that people were being advised to shelter in place to slow the spread of COVID-19. USDC lost its dollar peg the same day, dropping to $0.97.

Brent Xu, CEO of Umee, a layer-one interoperability chain built on the Cosmos ecosystem—the same as Terra—said he’s optimistic UST will be able to restore its peg. But he pointed out that USDC and USDT aren’t totally immune to market trouble.

“Since these coins are fiat collateralized, there is less risk of dramatic fluctuations in the value of their currency reserves—provided they actually have 1:1 backing,” Xu told Decrypt in an email. 

Over the seven years it’s been trading, Tether has published a total of eight assurance reports about its reserves. 

As of Tuesday afternoon, Tether reserves were 84% cash, cash equivalents, and commercial paper; 5% corporate bonds and precious metals; 5% secured loans and 6% in other assets, like cryptocurrencies.

But the ratio of commercial paper, which is unsecured, short-term debt issued by a corporation, has been a source of concern. On Tuesday, it accounted for 37% of Tether’s cash reserve. 

In September 2021, Chinese real estate developers Evergrande and Kaisa were at risk of missing a U.S. dollar bond payment—the type of commercial paper that made up $30.6 billion of Tether’s $69 billion reserve at the time.

Centre, the consortium behind USDC, last published a detailed breakdown of its cash reserves as of October 2021. At the time, it reported that all $33 billion of its reserve was in cash or cash equivalents and that none was in commercial paper. But it hasn’t provided that kind of breakdown since then.

It’s worth pointing out that neither Tether’s assurances nor USDC’s attestations provide the transparency of a full-blown audit, which would be a lot more rigorous.

Derek Lim, head of crypto insights at derivatives exchange Bybit, said that while Terra’s fate doesn’t pose a direct threat to USDC or USDT, they are still linked in a big way through the Curve 3pool, which allows investors to trade stablecoins for one another.

“I don't see any immediate risk to Tether and USDC (from the UST collapse) as they have a very different modus operandi,” he told Decrypt in an email. “In fact, UST has been keeping its peg partly because of USDT and USDC (and their deep liquidity), via UST's peg to the Curve 3pool.”

By his logic, the liquidity in Curve’s 3pool—and the fact that a large portion of that is made up of asset-backed stablecoins USDT and USDC—has helped maintain UST’s dollar peg. Or at least that would have been the case before Curve started displaying an alert to investors that, at $0.90, the UST exchange rate was too low for trades.

Editor's note: This story was updated after publication to include comments from a Circle representative.