Collapse of another algorithmic stablecoin highlights litigation risks for investors

Over USD 500 billion dollars was wiped off the value of all cryptocurrencies during the first 12 days of May, following the collapse of the Luna cryptocurrency and its sister stablecoin, TerraUSD (UST).

Luna had previously been trading at USD 80, with a market cap of USD 27 billion, and UST was the world’s third largest stablecoin. At the time of writing Luna’s price is one hundredth of a cent, and its market cap is USD 1.1 billion. The crash of Luna was precipitated by the breaking of UST’s peg with the US dollar. In South Korea, investors have already launched litigation and more lawsuits may follow there and elsewhere.

This post summarises what led to the downfall of Luna and UST, discusses causes of action that may arise from both algorithmic and traditional asset-backed stablecoins, and highlights the key litigation challenges in respect of blockchain technology.

Stablecoins

Stablecoins are cryptographic tokens that aim to maintain a stable price by linking their value to a reference asset, such as the US dollar. There are two broad categories of stablecoins:

Asset-backed stablecoins: These are backed by reserves of the reference asset (or other assets). For instance, one token might give the tokenholder a right to a portion of the reserves equal to a specific amount of the reference asset (for example, one token of a US dollar stablecoin might entitle the tokenholder to redeem the stablecoin for one US dollar).

Algorithmic stablecoins: These use algorithms, often implemented by smart contracts using preset formulae, that attempt to maintain their peg by controlling the supply of the stablecoin. For example, an algorithm could attempt to maintain the relevant stablecoin’s peg through the destruction or creation of the stablecoin and/or a sister cryptocurrency whose price is allowed to fluctuate:

• If the value of the stablecoin falls below the pegged value, new sister coins are created to purchase stablecoins, which increases the price of the stablecoin.
• By contrast, if the value of the stablecoin rises above the pegged value new stablecoins are created in exchange for the sister coin which is then destroyed, reducing the price of the stablecoin

Pools of assets may also be used to support the peg for an algorithmic stablecoin. This was the case for UST. The operation of such a pool is not an intrinsic part of the structure of the stablecoin, as it is for an asset-backed stablecoin, but it may still increase the strength of the peg in practice and, from a legal as well as economic perspective, gives the stablecoin hybrid characteristics.

Luna and UST

The price crash of Luna stemmed from UST ceasing to maintain its one-to-one peg with the US Dollar. The failure of the peg prompted a large sell off of Luna, the primary asset used to back UST, creating a vicious cycle as the smart contract, following the algorithm intended to re-establish the peg, created more Luna, which led to further downward pressure on the price of Luna and further creation of Luna by the smart contract.

Litigating the collapse of stablecoins

The collapse of Luna and UST has raised the question as to what causes of action, if any, holders of either may have against other parties. While there are analogies to be drawn between stablecoins and classical banking models – such as the gold standard – the law has not yet had time to consider the full scope of parties’ obligations to one another in respect of stablecoins. Nor, in most jurisdictions, has banking regulation caught up with the development of stablecoins.

As Luna and UST employ public decentralised blockchains, claims based in contract may be difficult to establish. Attempts to define the relationships between the various types of users (e.g., developers, oracles, validators, tokenholders) in public blockchains generally do not amount to legal contracts (although ‘governed blockchains’ may be an exception – see our analysis here: Legal analysis of the governed blockchain). Enforcement of such arrangements is, at best, untested and faces daunting preliminary issues as to jurisdiction and governing law.

Accordingly, claims based in tort appear more likely than claims based in contract. The question of whether a duty of care or a fiduciary duty is owed by a developer of a traditional cryptocurrency to an owner of that cryptocurrency was recently considered by the English High Court. While the court found that no duty of care or fiduciary duty was owed, it did not rule out duties existing in other circumstances. Our recent article discusses the potential circumstances in which a duty of care or fiduciary duty may be imposed: High Court rejects claim blockchain developers owe duties to users.

Another possible basis for tort liability is the argument that a stablecoin operator (or governing board) owes its users a duty of care not to carelessly permit the peg to break. Algorithmic stablecoins operate via smart contracts without ongoing supervision, where imposing a duty of care appears challenging (although not impossible, when arguments based on agency and partnership are considered). But for asset-backed stablecoins, or where – as with Luna and UST – there is a basket of assets that is used to support the peg, a duty of care may be more plausible.

Finally, tort liability may be based on negligent misstatement. Potential claimants will be examining statements of support by developers and operators of Luna and UST to determine whether these may impose a duty of care. It would be necessary to find an assumption of responsibility by the person making the statement, which was relied on by investors and known and intended to be relied on. These sorts of statements seen by investors are commonly subject to regulatory control, but here, if no regulation applies, it will only be tort liability that is relevant.

Litigation risks when transacting on a blockchain

The collapse of Luna and UST has highlighted the risks of DeFi, not only in the underlying investments, but also in the legal rights and obligations attaching to those involved in DeFi. While the question of how disputes arising from DeFi transactions will be resolved is still largely uncharted territory, we consider the major areas of risk involved in litigating a dispute arising from a transaction on a blockchain to be:

1. What is the nature of the legal relationship between participants in DeFi transactions?
2. Will agreements entered into via DeFi protocols satisfy the necessary formalities to be considered binding legal contracts?
3. When disputes arise as to the terms of an agreement entered into via DeFi protocols, how will a court interpret the agreement?
4. What remedies will be available to the parties to enforce their legal rights?
5. How will the successful party/ies enforce a court’s decision?

Our detailed discussion of these risks was published in March 2022’s volume of The International Journal of Blockchain Law (see page 16). Above all, care should be taken to ensure that transactions are documented in a way that clearly defines the legal relationships between the parties and provides a mechanism for resolving disputes and implementing the decision.