This is an audio transcript of the Behind the Money podcast episode: A crypto vibe shift?

Michela Tindera
Cryptocurrency prices have been dropping since late 2021. But for one week in mid-May of this year, something particularly dramatic happens.

Ethan Wu
In crypto, things tend to fall apart pretty quick.

Michela Tindera
That’s Ethan Wu. He co-writes Unhedged. It’s the FT’s daily newsletter about markets and finance.

Ethan Wu
The crypto market is turning down. That puts a lot of selling pressure on these currencies, and it creates a generally fragile environment where a little bit of pressure can really cause something to crack, especially if the foundations are themselves not particularly sturdy.

Michela Tindera
Now, there’s supposed to be something in the crypto space that doesn’t crack, or at least it’s not supposed to. It’s another type of cryptocurrency known as a stablecoin. The point of a stablecoin is to help crypto investors more easily jump from a traditional currency like dollars or euros into crypto. While cryptocurrencies you might have heard of like bitcoin and ethereum are really volatile. The point of a stablecoin is that it’s always supposed to be a 1 to 1 exchange. Like one stablecoin equals one US dollar. And so during this time, this downturn starts to impact a certain stablecoin.

Ethan Wu
There’s a stablecoin called terra. And then there is like a sister cryptocurrency called luna, which if they interact to ensure that terra is equal to $1.

Michela Tindera
Terra, the stablecoin, collapses in value and loses its peg with the dollar. Then luna’s price sinks like a stone. The cryptocurrency’s price drops to zero. And because luna and terra are interlinked, it’s bad news for both of them.

Ethan Wu
The entire system is predicated on people’s faith. Once people’s faith gives out, you get a death spiral dynamic where a loss of confidence leads to a loss of confidence and so on and so forth. To where it’s $0 instead of $1.

Michela Tindera
So the panic over terra luna then starts to spread and it makes its way to an even bigger stablecoin called tether. Tether is the stablecoin. It’s the largest one in circulation. The point of tether is that it’s supposed to be firmly locked to the US dollar. One tether token equals one US dollar. And as the panic rips through crypto and stablecoins, tether becomes untethered. It loses its peg and sinks to just above 95 cents.

Ethan Wu
It starts to give way. Crypto is seriously in trouble. It’s started to make people concerned. You know, are we playing with a house of cards here? How sturdy is this entire ecosystem?

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Michela Tindera
So at the end of this week, in mid-May, you have two stablecoins that are not looking so stable. And that calls into question really people’s faith in crypto. In today’s episode, we explore what happened with these stablecoins, how they’re different, and what they can tell us about the future of crypto. I’m Michela Tindera, and this is Behind the Money, a podcast about business, money and power.

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Michela Tindera
Hey, Ethan, welcome to the show.

Ethan Wu
Yeah, thanks for having me.

Michela Tindera
Could you just kind of simply explain what a stablecoin is for people?

Ethan Wu
Stablecoins are a very important part of the crypto ecosystem. If you’re not in crypto, these don’t matter to you at all. In a lot of ways, it’s kind of a crypto only thing. But if you are in crypto, this is a key way that you’re moving between dollars and cryptocurrency or between different types of cryptocurrency. And one of the reasons for that is, as everyone knows, you know, bitcoin, ethereum, all these cryptocurrencies are highly volatile. You can gain $1,000, lose $1,000 in an hour. And so when you’re doing trades, if it takes you like an hour to make up your mind on a good trade, you don’t want to be losing money because the currency just like moved against you because it’s just so volatile.

Michela Tindera
OK. And are there different kinds of stablecoins?

Ethan Wu
So the confusing thing about the word stablecoin is that there’s a lot of different stuff that gets called by the same name but doesn’t work at all like each other. So I’m gonna make a distinction. The distinction is between what are called asset-backed stablecoins and algorithmic stablecoins.

Michela Tindera
Ethan says terra is an algorithmic stablecoin.

Ethan Wu
These work with computer magic. These work with a lot of like gizmos and gadgets that try to assure that one algorithmic stablecoin will equal $1. The basic gist is these algorithmic stablecoins are programmed to incentivise people to either, if they’re above a dollar, push them down to a dollar, or if they’re below a dollar, push them up to a dollar.

Michela Tindera
So trust in the system is really important for algorithmic stablecoins.

Ethan Wu
Because they’re not tied to any kind of real world asset, a lot of those algorithmic mechanics depend on people believing in the system. And the second that people’s trust evaporates, you’re in a pretty sticky situation where you can get a death spiral, where a loss of confidence leads to a loss of confidence, which leads to a loss of confidence. And then the whole house of cards starts falling apart.

Michela Tindera
And then there’s tether. That’s an asset-backed stablecoin. That means its reserves are in traditional assets like Treasury bonds or commercial paper.

Ethan Wu
If I lose faith in tether, right? What I do is I call tether up and I say, Hey, I don’t believe in your project any more. I want my money back. Can you. I have a hundred tether, please give me $100. And so tether will take their $100 of let’s say it’s Treasury bonds. And they’ll sell that on the open market, get 100 bucks and then give me those hundred bucks. And so I don’t have faith in the project, but I’ve been made whole, so I’m fine and then everyone else will see, Hey, this guy lost confidence, but he got his money back. So we’re fine too. Really, because worst comes to worst, we’ll just redeem our money.

Michela Tindera
Ethan says another way of putting this is to think of tether like an unregulated bank.

Ethan Wu
That’s not literally true, but I think it’s a very, very close approximation. And I think the very concerning thing is, you know, we’ve discovered in financial history that banks are exposed to bank runs. If everyone tries to redeem their deposits at the same time, the bank runs out of cash. They can’t meet all these redemptions.

Michela Tindera
When terra luna crashed, tether briefly dropped down from its one US dollar peg to 95 cents before bouncing back up to $1 again. Ethan says that a blip like this matters for two reasons. Firstly because of the bank run scenario, but also because the crypto market is dependent on tether to make trades.

Ethan Wu
So if tether can’t consistently stay at about $1, it’s really hard to do any trading in this market. The entire market becomes very brittle if tether doesn’t work the way it’s supposed to.

Michela Tindera
So that’s what’s at stake here. These coins help make the crypto markets tick, and in order for them to work, they need believers. But if you look at what happened in May, it looks almost as if belief in crypto itself is starting to crack. But why May? Why now?

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Michela Tindera
Ethan says the crypto market is all about vibes, and recently the whole economy has felt unpredictable.

Ethan Wu
So when people started getting scared about the state of inflation, the state of economic growth, the state of interest rates rising, which again makes money a little bit scarcer, that leads to a general vibe of, ‘oh shit, we need to sell, we need to get out, we need to protect ourselves’. And especially if Bitcoin is at $69,000 and I bought at 30,000, hey, maybe I should take some of my gains here. Maybe I should convert these paper gains, theoretical gains into cash that I can actually, you know, buy stuff with.

Michela Tindera
The value of crypto has been on a downward trend since November 2021, pretty much in line with the stock market. Ethan says people are just feeling nervous about risky assets.

Ethan Wu
Let’s sell speculative stuff and all the speculative stuff. Meme stocks, crypto, high growth technology stocks, those all started falling at about the same time.

Michela Tindera
But Ethan says there really isn’t some complex explanation as to why terra luna specifically dragged tether down with it.

Ethan Wu
There’s no specific reason. Terra luna crashing should cause tether to unlink, but crypto is a lot about vibes. It’s about sentiment. It’s about how people feel. When people get scared, they run for the hills. And I think that’s really what you saw is, you know, terra luna crashed and people were like. Like, Oh, crap, you know, is this a broader problem in stablecoins? And they started selling their tether. But I think the fact that tether bounced back within an hour or two shows that it really was kind of like a temporary worry rather than like a fundamental fear that tether’s reserves are like like bogus or garbage or whatever.

Michela Tindera
So what’s going on with terra now?

Ethan Wu
Right now the project looks dead. There are attempts and some talk about reviving it in some form. Watch to see how that plays out.

Michela Tindera
So since algorithmic stablecoins are based on investors’ trust in the system, what does that mean for them going forward?

Ethan Wu
I would expect that people will invest less in these projects, in these algorithmic stablecoin projects. They don’t look very stable, really. I think whether terra or luna makes a comeback, this, I think, was really it’s like 15 minutes of fame. Because, again, I don’t think it is fundamental to the crypto market in the way that tether is. It’s just more of a, it’s more of a symbol of the things that have gone wrong as crypto has exploded in value without some of those regulations and best practices evolving alongside with that growth.

Michela Tindera
So with terra, since the project’s collapsed, what does that mean for the people who would have had investments in this? Are they all down to zero?

Ethan Wu
I mean, they’ve lost everything, really. Maybe some were able to get out a little early, but for the most part, if you held terra or its counterpart cryptocurrency, luna, you’re just you’re SOL. You lost a ton of money. I think there’s a lot of talk about a lot of threads contemplating suicide popped up on the luna terra forums. And, you know, I think this is still a very young space and people should be careful about the kind of money that they put into it. Anything that you put in a crypto, you should be ready to lose as I think this terra luna incident shows very clearly. But the broader message here is that, you know, emerging markets need guardrails because the people that are most likely to get burned are the people that can least afford it and have the least amount of information.

Michela Tindera
Like Ethan said, people who had invested in luna realised they had lost a ton of money. Terra turned out to not be a very stable stablecoin, but many investors have placed their bet on tether to keep things secure. But here’s the thing about tether. We don’t have all the details on what kinds of assets are really backing it, and that could have potential consequences beyond crypto, even into traditional markets.

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Michela Tindera
The make-up of tether’s reserves has changed over time.

Ethan Wu
When tether first launched, their promise was: for every tether we issue, we have one US dollar in a bank account. Very simple. Very straightforward. And then, you know, over time that language started to get a little bit looser. It’s like, oh, we have, for every tether we have one US dollar or US dollar equivalents. What is equivalent to a US dollar? In theory, a dollar of stocks is equivalent to a US dollar. But like, not really because the price goes up and down, right? So tether started, it started becoming clear to people on the outside that tether was holding riskier assets.

Michela Tindera
But even though it seems like the assets are riskier, the problem is we don’t really know.

Ethan Wu
Basically, people have asked, what are you guys holding? And they’re like, Hey, look, you know, we have all these assets and people are like, can we get like a regular audit that every other company on the face of the earth has to do? And they’re like, no, you cannot (laughter) you cannot get an audit.

Michela Tindera
Instead of releasing audited statements, tether releases what are called attestations, which Ethan says doesn’t really provide a clear picture of what tether is holding. He says it could be almost like an online dating profile.

Ethan Wu
An attestation is just a snapshot, right? And as anyone who’s used Tinder knows, a snapshot of someone’s face is not what they actually look like, right? Like, you know, like your appearance changes every day. Like, you know, you wake up with bad hair or you look worse one day or whatever. And tether has basically done the equivalent of that (inaudible), you know, financial holdings that they’ve taken like, you know, the a selfie on like their best hair day and like that’s their financial, that’s their balance sheet.

Michela Tindera
Tether’s chief technology officer has previously told the FT that the company bought, quote, a ton, unquote, of US government debt. He declined to give details about its $40bn hoard of US government bonds because he did not, quote, want to give our secret sauce, unquote. But Ethan is worried about a bank run situation. That could happen if tether can’t consistently stay at its $1 peg. Enough people could get scared and pull out their money. That could scare other people to pull out their money. And then the whole thing would go downhill from there.

Ethan Wu
If there were a run on tether, would the whole thing collapse, thereby bringing down the entire crypto market with it? And would tether, having to rapidly sell all of its assets off, cause chaos in traditional financial markets? You can imagine if you try to dump $50bn in Treasury bonds or $50bn in other types of corporate debt, you know, these markets are not made to absorb that much selling at, you know, in a very concentrated period of time. That could cause serious chaos. Personally, I think that especially given the very high plausibility, the high likelihood that tether could destabilise public markets, that it’s in the public interest, that everyone knows what they hold.

Michela Tindera
Still, when the May crash happened, Ethan says the value of an asset-backed stablecoin really showed. Terra went through the floor because it’s not linked to anything. But tether has a defence mechanism.

Ethan Wu
They have the ability to redeem their dollar assets. I see it as really somewhat reassuring that this asset-backed stablecoin, despite all of the serious questions about its holdings, is able to meet some amount of redemptions in a period of chaos. It’s able to use its dollar reserve cushion to protect itself from lots of people losing faith in the project. And that’s how you maintain faith, is that you prove yourself in times of chaos.

Michela Tindera
In fact, investors pulled some $7bn out of tether in the days after the brief unpacking. And it appears to have worked out quite smoothly. The people who wanted to take their money out seem to have gotten it back. But events like this still make regulators nervous.

Ethan Wu
US regulators and European regulators have been very clear that this needs some serious like bank-style regulation. Or if not bank style, something specific to stablecoins. This does need better oversight.

Michela Tindera
You think it’s a good idea for them to be regulated? How realistic do you think that is, that something will come about? Do you think anything changed over the last few weeks with that?

Ethan Wu
I think the argument for stablecoin regulation has been very clear and this didn’t do much to change the substance of the argument. I think what this episode did do is reinforce the urgency of these regulatory efforts to the people in charge that this type of stuff could blow up at any moment. We’re never gonna know how bad it is until it happens, and we’re probably not going to get lots of advanced warning.

Michela Tindera
If regulations don’t come in, let’s just say, you know, this kind of talk of calling for regulation continues. Continues. Regulations don’t come in. What does that mean for crypto in general?

Ethan Wu
I would say if stablecoins are not tightly regulated, then you’re going to see lots more warnings about how risky these things are. And perhaps one of these days we see a really significant blow-up that spills into traditional markets. I think something you saw after the, after tether very briefly unpegged from $1, was people speculating about what the worst-case scenario could be. And I think here we just don’t exactly know. People are guessing. In many ways, that’s the worry part, is that we don’t really know how deep the damage could be. And I think as we discovered in previous financial crises and certainly in 2008, that the full depth of exposure to ordinary people’s lives and to traditional financial markets more broadly is only really knowable once the pain has happened. And at that point, you’re pretty unhappy, right? It’s too late.

Michela Tindera
So for the “cryptogeddon” that wasn’t in May, terra luna crashed and tether only briefly unpegged. It could have been a lot worse. But the stablecoins, at least tether, did what they were supposed to do. But there are still big questions surrounding tether. We’ll be back next week with a deep dive into the eccentric and sometimes mysterious pasts of Tether’s top executives.

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That’s it for this week’s show. Thanks for listening. To hear more from Ethan, you can subscribe to the Unhedged newsletter at FT.com. Behind the Money is hosted by me, Michela Tindera. Stephanie Horton is our contributing producer. Persis Love produced this episode. Topher Forhecz is our executive producer. Sound design and mixing by Sam Giovinco. Thanks to Gregory Meyer. Cheryl Brumley is the global head of audio. Thanks for listening. See you next week.

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