Efficient Frontier
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Efficient Frontier

Terra stablecoin collapse: the simple version

This week the Terra Luna ecosystem rattled the crypto world when its $18.6 billion tokens fell from $1 to $0.2, now at $0.08 (Update on March 16th)

If you want to learn more about the details click here ,but suffice it to say that no “algorithmic stablecoin” has ever survived a Bitcoin market downturn. Terra wasn’t the first “algo stablecoin” to collapse, but it was the biggest one.

Simple stablecoins (which should be backed 1–1 with regular dollars) are more sturdy and have survived downturns. Fortunately, simple stablecoins comprise 95% of stablecoin trading in crypto markets, according to Coingecko data.

UST/Dollar chart. The collapse started on May 9th and is still playing out, currently UST is traded for $0.08

Algorithmic stablecoins usually offer various bootstrapped economic incentives which try to keep a token’s value pegged to 1 dollar. This usually doesn’t end up as expected.

The Terra project, founded in 2019, created a token named Luna, which was supposed to (somehow) back the UST token. Luna’s end has been even more volatile:

Above: Since May 9th Luna fell from $62 and is now trading at $0.002!

Terra was designed so that as the demand for UST grows Luna tokens are burned, creating upward pressure on the Luna price. On the flip side-redemption of UST created more Luna. This was a problem as Luna was meant to provide a backing for UST.

So what made Terra so successful? Easy — Terra offered users 20% annual interest on their UST if they deposited it to a program named Anchor, on the Terra blockchain.

The following image shows the rise and fall of Terra’s Anchor contract, which held $17.15 billion in UST and other assets 6 days ago. It held under $1 billion before the Terra blockchain was shut down today. (Note:It has now be turned back on.)

Source:DeFiLlama

Above: Assets held by Anchor protocol. As faith in the Terra Luna system faltered on Monday, UST holders rushed to withdraw the UST tokens from the Anchor protocol to trade them for other assets.

Bitcoin and DeFi

Two months before the crash, as the price of Luna fell , trying to quiet the doubts of Terra’s detractors, the Luna foundation purchased 42,530 Bitcoins in three weeks, saying they will use the roughly $1.2 billion worth of Bitcoin to help support UST.

When things got bad on May 9th, the Bitcoins got sent to various exchanges.

Source: Bitinfocharts

Above:Terra’s Bitcoin holdings

First they sent 14,000 Bitcoin to OKex exchange, and a few hours later the remaining 28,000 were sent to Binance. The use of these funds is unknown but it’s assumed at least part of it was used to try to prop up UST and Luna.

The collapse also disrupted on-blockchain DeFi activity:

$11.07 billion out of $18 billion UST in existence were deposited in the Anchor protocol and additional hundred of millions of UST were leveraged to get extra yield using the Anchor protocol and Abra.

After weeks of Luna being debated in the online crypto community, large redemptions started a panic and users started withdrawing funds.

With the pressure of billions of UST fleeing Anchor to be exchanged, the price started crashing, which created hundreds of millions in liquidation of leveraged UST positions in Anchor and Abracadabra, the on-chain protocols.

On-chain DeFi liquidations jumped on May 9th and in the following 3 days from several million to hundreds of million a day, as people who leveraged their UST using DeFi apps were liquidated.

Source: Parsec

Above: On-chain DeFi liquidations per-day in the last week. The main venues were Anchor where $344 million was liquidated, and Abracadabra where traders lost $321 million

Though the Terra stablecoin was never destined to be long lived, its fast collapse nonetheless sent shockwaves across the crypto world. We hope this experience brings better awareness to this type of scheme.

Luna’s dubious financial design foundation worked wonders for the Luna price on the way up, but since November 2021 as the price of Luna kept coming down, increasing worries about the fate of the $18 billion stablecoin market cap grew.

Dubious design, greed and obfuscation created a shaky ground for the Terra stablecoin. It’s likely this is not the last crypto project that will have similar failures in years to come, so it’s always good to be skeptical, especially if it sounds too good to be true.

On the other hand- don’t take Terra for the rest of the crypto stablecoin complex. There is a huge variety of products in the crypto world, because it’s open source, and the large majority of traded stablecoins are the most simple and yes, the most stable assets in crypto, even today.

Published courtesy of Efficient Frontier

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With over 12 years of high frequency and algorithmic trading experience, our technology powers weekly over $1 Billion of trade. We’re passionate about digital assets and our mission is to bring professional, trusted technology that adds value to the industry and the markets.

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Sarah Wiesner

Sarah Wiesner

@efrontier_io, @bitcoinembassy

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