A "black swan" event is unpredictable, goes beyond what is normally expected of a situation, is obvious in hindsight, and has potentially severe consequences. Examples include the subprime crisis and subsequent collapse of the banking sector in 2008, and the market capitulation following the outbreak of the global pandemic.
In the financial markets or in any other industry, Black Swan events are usually known to be negative. But history shows that these events are also a fulcrum for positive systemic change. I am convinced that this will be the case with this event as well.
Ahmed Ismail is resident and CEO of Fluid, a DeFi liquidity aggregator, and co-founder of HAYVN, a regulated over-the-counter trading venue in the Middle East.
The demise of UST as an algorithmic stablecoin is a Black Swan event and should never have happened. It was a project worth over $18 billion - practically too big to fail. Stricter regulatory controls overseeing the project's automated trading system could have defused the situation long ago.
Terra's meltdown spread to Bitcoin, causing its price to drop by $10,000 in a matter of hours. It also did a lot of damage to our colleagues in the crypto industry, especially exchanges and small and large investors.
If automated decentralized financial trading (DeFi) systems are to reach such proportions, better regulation and stakeholder protections are needed.
Risks associated with algorithmic stablecoins.
What has come to the forefront this week are the risks associated with algorithmic stablecoins. The key message is that computer code cannot replace asset-backed collateral.
An algorithmic stablecoin is not backed by assets, but is stabilized by one or more algorithms designed to hold the peg. Many "algos" failed before UST, but this historic collapse now proves that algorithmic stablecoins have gaps in their architecture.
Unfortunately, this gap in the design of the Terra network caused a multi-billion dollar project to nearly fail in a matter of days. It also caused systemic risk for DeFi and the entire crypto industry.
The network's builders, primarily Terraform Labs, tried to defend the UST/USD peg by selling large amounts of BTC they held in reserve.
A silver lining: it appears that asset-backed stablecoins such as USDT, USDC and BUSD have weathered the storm, and investor sentiment remains intact, even if they have not remained untouched. USDT, for example, moved almost 5% away from its USD peg on Thursday, showing how extreme volatility affects the price of stablecoins that are supposed to be 100% asset-backed.
This event has highlighted important lessons that need to be internalized by the DeFi industry: Algorithmic stablecoins do not work, or at least need much more research and development. Also, regulatory and technological controls need to be put in place before another algorithm can become this large.
Crypto must be able to handle extreme volatility
This is not the first black swan, nor will it be the last. They will happen again in the future. But the big question is why there were systemic impacts that affected other assets in the market, and how to mitigate them.
The answer boils down to liquidity, volatility, and how markets respond to black swans. Crypto markets are illiquid and thinly traded. Liquidity is isolated, and crypto markets are extremely inefficient. They are particularly vulnerable, and even the most stable cryptocurrencies like BTC and ETH are vulnerable. All assets will falter if liquidity cannot flow.
That's why crypto markets need liquidity aggregators. These systems could help investors manage the turbulence caused by black swans - when volatile conditions occur, market participants need access to liquidity quickly and at the best possible price to maintain equilibrium.
As for regulatory controls, I'm sure lawmakers will look at the implosion of one of the biggest crypto assets of all time and find ways to tame the industry.
This is just our industry growing and learning.