TerraUSD (UST) is an algorithmic stablecoin that is pegged at $1.00. But, on the evening of May 19, it was trading for $0.083.
This isn’t supposed to happen, of course, but last week UST, along with its affiliated coin Terra (LUNA), performed a sort of death spiral that “wiped nearly $50 billion of investor wealth in a few short days,” according to NYDIG’s May 13 newsletter.
The crash shook the crypto sector, but it also raised some questions: Is this about a single flawed project or is it also about an entire class of cryptocurrencies — algorithmic stablecoins — which use an arbitrage mechanism instead of fiat reserves to keep their market price stable? That is, are algo stables inherently unstable?
Also, how have last week’s events affected more traditional stablecoins, like Tether (USDT), the industry’s largest, but which also briefly lost its 1:1 peg to the United States dollar? And, what about implications for the cryptocurrency and blockchain space generally — has it too been tarred by UST’s fall?
Finally, what lessons, if any, can be drawn from the week’s tumultuous events so that this doesn’t happen again?
Can algo stables survive?
As the dust settles, some are asking if the UST/LUNA flatlining spells the beginning of the end for algorithmic stablecoins as a class. For the record: Some algo stables, including UST, may be partially collateralized, but algo stables rely mainly on market maker “arbitrage” activity to maintain their $1.00 market price.
Pure algo stables, which put up no collateral at all, are “inherently fragile,” according to Ryan Clements, assistant professor at the University of Calgary Faculty of Law. They “rely on numerous assumptions for operational stability, which are neither certain nor guaranteed.” As he further explained to Cointelegraph:
“Specifically, they require ongoing demand, willing market participants to perform arbitrage and reliable price information. None of these are certain and all of them have been tenuous during times of crisis or heightened volatility.”
For these reasons, last week’s bank run on LUNA and UST and the ensuing “death spiral” that resulted could have been predicted, said Clements, who indeed warned of something like this in an October 2021 paper published in the Wake Forest Law Review.
“Prior to the failure of UST, I argued that algorithmic stablecoins — those that are not fully collateralized — are based purely on confidence and trust in the economic incentives of the stablecoin issuer’s underlying ecosystem. As a result, there is nothing stable about them.”
“I don’t see how algorithmic stablecoins can survive,” Yves Longchamp, head of research at SEBA Bank — a Swiss regulated digital assets bank — told Cointelegraph. Last week’s drawdown in the stablecoin space showed that:
“Not all of them are created equal and that quality matters. Relatively transparent, fully-collateralized fiat stablecoin USD Coin does better than somewhat opaque fully-collateralized fiat stablecoin Tether, which, in turn, does better than partially collateralized, algorithmic stablecoin UST.”
Is more collateral the answer?
Others, like Ganesh Viswanath-Natraj, assistant professor of finance at Warwick Business School, agreed that algo stablecoins are “inherently fragile,” but only insofar as they are under-collateralized. They can be shored up by “dollar reserves or an equivalent in stablecoins on the blockchain. Alternatively, they can adopt a system of over-collateralization through smart contracts.” The latter is how decentralized stablecoins like Dai (DAI) and Fei (FEI) work.
Kyle Samani, co-founder of Multicoin Capital, largely agreed. “The problem with UST wasn’t the algorithm, but the lack of collateral.”
“An algorithmic stablecoin is very challenging,” Campbell Harvey, Duke University finance professor and co-author of DeFi and the Future of Finance, told Cointelegraph. “Every time you’re under-collateralized, you run the risk of a so-called bank run.”
What was worse in the UST case is that it used an affiliated cryptocurrency, LUNA, to help keep its price steady. LUNA was “highly correlated with the fate of UST,” said Harvey, and when one began to sink, the other followed, which drove the first token’s price down even more, and so on. He added:
“Does this mean it will be difficult to launch another algorithmic stablecoin? Yes. Does this mean the idea disappears? I’m not sure about that. I’d never say never.”
What is more certain is that UST was using a flawed model, insufficiently stress-testing and lacking in circuit breaking mechanisms to break the fall when the death spiral began, said Harvey.
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cointelegraph.com