Broken stablecoin could intensify crypto regulation push

A stablecoin called TerraUSD (UST) — and the cryptocurrency that backed it, Luna — seem to have entered a doom loop in recent days, vaporizing billions in illusory wealth and demonstrating the potential pitfalls of poorly thought-through crypto hijinks.

Why it matters: The spectacular blowup will bolster the push for regulation of stablecoins, the creations that serve as the actual money used in the crypto and DeFi economies.

Driving the news: UST continues to struggle, falling another 25% on Wednesday, to $0.68 shortly after 4 p.m. E.T. Luna fell a remarkable 95%, to around $1.25.

Catch up fast: Stablecoins are basically a type of cryptocurrency designed to avoid the wild swings seen in traditional cryptos like Bitcoin, Ether and Solana.

• Stablecoins are supposed to maintain a value of $1. They're mostly used on crypto trading platforms, which typically don't allow dollar-based accounts.

How it works: Most stablecoins you've heard about in the news are dollar-backed, meaning each token is backed by traditional money.

• In contrast, UST is an algorithmic stablecoin, meaning it derives its value — in part — from computer programs that automatically adjust supply of the coins in response to rises and falls in demand.

Yes, but: For UST it was clearly not that simple.

• It's true that UST was designed so that the amount of the coin that could be created or destroyed — "minted" and "burnt," in crypto-speak — changed in response to prices.
• But UST was essentially backed by another cryptocurrency, something called Luna.

It gets even more complicated. When UST value fell below $1, traders could "burn" one UST and be paid to do so with $1 worth of Luna.

• The traders then pocket the small difference between the sub-$1 price of UST and the $1 worth of Luna, in a seemingly low-risk kind of trade known as an arbitrage.
• In the aggregate, all of this arbitrage trading would shrink the supply of UST — which would help raise the price back to $1.

Our thought bubble: I guess this could work, if Luna was really worth something. But why would Luna be worth anything? Well, as we're seeing this week, the market has decided it is not.

• The value of Luna, as envisioned by the people who came up with this system, depends entirely on people wanting to use UST. That's because the way you create, or "mint," new UST is by destroying, or "burning," Luna. As the supply of Luna dwindles, its price rises — at least in theory — creating a supply of value to be used to shore-up UST.

• Ok, but what if people decide that they don't think UST is worth anything and they also don't think Luna is worth anything? What if the whole thing is made up and worthless?
• That's kind of what we're seeing now. In such an instance, the whole thing collapses.

What to watch: In and of itself, the collapse of UST and Luna don't seem like they should be large enough to pose a major problem to the broader markets and financial system.

• But the question is whether this stablecoin run — like the bank runs of yore — will generate a bunch of others, as people rush to convert their stablecoins to actual dollars.
• The entire stablecoin market is roughly $160 billion in market capitalization, according to Fitch Ratings. And that might be big enough to cause a bit of a ripple beyond cryptoworld.