The spectacular implosion of the Terra ecosystem in mid-May left the crypto industry scarred. Though there were some brave critics who understood just
The spectacular implosion of the Terra ecosystem in mid-May left the crypto industry scarred. Though there were some brave critics who understood just how thin the razor’s edge was for TerraUSD (UST) — now TerraUSD Classic (USTC) — I think it’s safe to say that most people didn’t expect Terra to fail so fast, so dramatically and so completely irrevocably.
I’m writing this as the Terra community is voting on a plan to restart some kind of Terra 2.0 — a plan to salvage the layer-1 ecosystem without the UST stablecoin. The old Terra, now to be known as Terra Classic, is completely dead. An ill-fated attempt to backstop UST holders printed trillions of LUNA tokens, destroying their value and ultimately jeopardizing the safety of the network itself.
The complete wipeout of $50 billion in value seems to have made people decide once and for all that algorithmic stablecoins cannot work. But I think it’s important to have a more nuanced understanding of why the original LUNA failed and how others can learn from its lessons.
Related: Terra 2.0: A crypto project built on the ruins of $40 billion in investors’ money
Stablecoins: New name for an age-old concept
The term stablecoin mostly evokes United States dollar-pegged currencies that aim to maintain a $1 value. But it’s important to remember that this is mostly a matter of convenience. The same mechanisms underpinning today’s USD stablecoins can be used to create coins that are pegged to the euro, gold, even Bitcoin (BTC), Nasdaq futures, or some specific stock, such as Tesla (TSLA).
It’s also interesting to note that stablecoins are not really a new crypto idea. Today’s stablecoin designs are closely related to either how money works under a gold standard — e.g., Maker’s Dai is a claim to a hard collateral just like early banknotes were claims to a gold vault — or they’re a reproduction of pegged currencies such as the Hong Kong dollar.
The HKD is a very interesting example in all of this because it’s pretty much your run-of-the-mill “algorithmic stablecoin.” It’s pegged to the U.S. dollar, even if not at a 1:1 ratio, and the HK central bank uses its vast reserves to keep HKD’s price in a well-defined ratio by trading it on the market. The latest audits place the Hong Kong reserves at $463 billion, which is six times the HKD in immediate circulation and almost half of its M3, the broadest definition of “money” that also includes not immediately liquid assets (like locked bank deposits).
Really the only reason why HKD is technically not an algorithmic stablecoin is that there is a central bank conducting market operations. In decentralized finance (DeFi), the central bank is replaced by an algorithm.
Related: UST aftermath: Is there any future for algorithmic stablecoins?
Terra ain’t no HKD, though
Conflating Terra with the algorithmic stablecoin space, in general, fails to see why Terra collapsed as hard as it did. It’s important to realize just how fragile the Terra protocol design was. In a nutshell, UST was “collateralized” by LUNA, the gas token of the Terra blockchain. Since there was a fairly solid DeFi and nonfungible token ecosystem developed on Terra, the LUNA token had some inherent value that helped boost the initial supply of UST.
The way the mechanism worked was, in principle, similar to HKD. If UST traded above $1, users could acquire some LUNA and burn it for its dollar value in UST. Crucially, the system assumed that UST was worth $1, so the LUNA burner can just sell the UST on the market for, say, $1.01 and make a profit. They can then recycle the profits into LUNA, burn it again, and continue the cycle. Eventually, the peg would be restored.
If UST traded below $1, the reverse mechanism helped backstop it. Arbitrageurs would buy the cheap UST, redeem it for LUNA at a rate of 1 UST equaling $1, and sell those tokens on the market at a profit.
This system is great at keeping the peg in normal circumstances. One issue with Dai, for example, is that it can’t be directly arbitraged for its underlying collateral. Arbitrageurs need to “hope” that the peg stabilizes to make a profit, which is the primary reason why Dai is so reliant on USD Coin (USDC) now.
But we also need to mention the extreme reflexivity in Terra’s design. Demand for UST that makes it go above peg results in demand for LUNA, and thus, an increase in price. The keystone of this mechanism was Anchor, the lending protocol on Terra that guaranteed a 20% APY to UST stakers.
Where did the 20% APY come from? From extra UST minted through Terraform Labs’ LUNA reserves. A higher price of LUNA meant that they could mint more UST for Anchor yield, thus increasing UST demand and increasing LUNA’s price — thus they were able to mint even more UST…
UST and LUNA were in a cycle of reflexive demand that, let’s face it, had all…
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