Stablecoin UnStable?-Terra death trap
May 9th, 2022, will be known as the “Lehman Brother of Crypto,” but I want to coin it as “Terra brings Bitcoin along for a death spiral spin and kick start the Crypto Winter.”
Terra’s stablecoin UST, one of the top 10 cryptos by market cap, lost its peg to the U.S. dollar. Currently, UST is trading at 0.079, a staggering 92% loss.
This article will explain what a stablecoin is before we proceed to Terra UST and Luna demise.
What is a Stablecoin?
A token aims to act as an anchor to the volatile cryptocurrency market. Stablecoin (SC), like the name implied, is to maintain a stable peg ratio of a 1:1 fiat currency to stablecoin; For example, 1USD to 1SC.
Physical Assets backed Stablecoin?
A type of SC that is collateralized by tangible assets such as USD, Euro, physical metals such as gold, or even bonds to keep the price of the SC stable. At a glance, this spelled “safe” however, the critical points to take note of are:
- It is a centralized issuer, just like your traditional banks, except most banks, are FDIC insured.
- There is currently no regulation in place to audit the claimed 1:1 peg. It is up to the centralized issuer to stay in compliance by having enough tangible assets to cover all the SC in circulation.
- How liquid are the held assets in maintaining the peg?
USDC and USDT are the top physical assets backed SC in the crypto space.
Crypto Assets backed Stablecoin?
A type of SC collateralized by another crypto asset such as Bitcoin, Ethereum, etc. A crypto asset-backed SC kind of defeats the very purpose of SC as an anchor. To quell the critics, the solution is to over collateralize, such as a 1USD:1SC backed by 1.5 dollars worth of crypto. However, at the end of the day, it is an exchange of 1USD with 1 unit of faith backed by another 1 unit of faith, even when we factor in the over-collateralization. One may argue that the U.S. dollar is a fiat currency backed by faith, but let’s not forget we live in a world run by fiat, and the U.S dollar is still the petrodollar.
DAI is the leader when it comes to crypto-backed SC.
Algorithmic Stablecoin
Robert Sams first proposed it in 2014, A Note on Cryptocurrency Stabilization: Seigniorage Shares. The crux of the whole white paper was that the stability of an SC, both in price and in quantity, can be achieved through mimicking the central bank monetary policy, specifically Fed’s open market operations, minus the fractional banking system in a decentralized environment. Refer to the table for a summary of the money supply using the Fed’s open market operations.
In a decentralized algorithmic SC environment:
- Fed is replaced by a smart contract- computer code that contains the algorithm for stabilizing the price and quantity of SC
- SC can be pegged to USD in a theoretical manner, but SC is the one prime to be stabilized
- Assets, known as shares, the most critical component, must absorb the volatility of an SC. It should contain the mechanism to incentivize people to participate in stabilizing an SC
Back to the Terra blockchain, UST is Terra SC, and Luna is Terra native token. Luna holds the key to maintaining the UST to USD artificial peg through minting (creating) and burning (destroying) mechanisms. Refer to the table below on how it works.
To keep the algorithmic UST in a working condition, an ecosystem such as lending platforms, crypto wallets, and even insurance businesses are actively being built to incentivize people to stay in the Terra blockchain. Refer to the diagram for a complete picture.
There is no way that Terra would fail with a price drop to near-zero with such a vast ecosystem. However, remember how we rant about the Fed pumping trillions of dollars into the market, thus throwing the USD into a debasement trajectory and inducing the inflations we face today?
The funny thing is that the very same thing happened to Terra. What if someone holds a large enough UST decides to redeem it back to USD? This action alone will cause a dump of an excess UST into the Terra ecosystem and results in a UST price drop. The algorithm will be triggered, and Luna will be minted to absorb UST’s excess liquidity. This, in turn, causes Luna’s price to drop unless someone steps in fast enough and soaks up the excess Luna to keep Luna’s price stable. Terra users will lose confidence if any of these breaks, and mass selling will occur; thus, a death spiral is inevitable, rendering UST and Luna worthless. And this is precisely what happens to Terra.
To conclude, algorithmic stablecoin has proven unstable time after time, ranging from Tron Finance to Terra, and it is a failed economic experiment that destroyed people’s faith in the blockchain.
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