Does TerraLuna Expose Algorithmic Stables are Just Ponzi Schemes?
Every algorithmic stable coin is ultimately a tokenized arms race.
Terra and Luna are each halves of what was supposed to be a perpetual, algorithmic wealth machine made possible by the through the magic of financial engineering. The operative term there of course is “supposed to be”.
A bit of background (skippable if you know what Terra is)
TerraUSD, or UST, has been dragged into the spotlight in the last few days after the so-called stablecoin, which is supposed to be pegged one-to-one with the U.S. dollar, fell sharply below the $1 mark.
UST is an algorithmic stable coin which uses code to maintain its price at around $1 based on a complex system of minting and burning. A UST token is created by destroying some of the related cryptocurrency luna to maintain the dollar peg. In other words, both tokens are supposed to act as a balancing mechanism for each other, by which one is automatically created or destroyed based on the supply and demand of the other.
What Happened?
Luna was on a massive 1,000% run in recent months, mostly because it paid people to use the coin. How? well Terraform Labs (the company behind this backing from major investors like Coinbase Ventures, Pantera Capital, and Galaxy Digital) ran a lending program named Anchor, which paid users 18–20% interest, bleeding Terraform labs of liquidity. This when savings rates in the US are effectively zero and in the EU, negative.
You’re probably thinking there’s a liquidity squeeze on both sides in the offing. The Luna foundation even had a plan to defend Luna and Terra: a liquidity pool funded by $1 billion from large investment firms like Jump Crypto and Three Arrows Capital deployable to buy up Terra in case of a bank run. If this all sounds complex, refer to a Bloomberg columnist who called the scheme “insane.” Some have called this a a Ponzi scheme
Next, two investors — let’s call them “Bleakstone” and “Castle”, knowing this all operates like a Ponzi scheme, orchestrated a large withdrawal of money no one was prepared to cover. The basic plan was to borrow Bitcoin from Gemini, use the Bitcoin to but OTC and then dump UST to create a liquidity shortfall, tanking Terra, Luna, and the rest of the crypto markets. Then repay the loan with Bitcoin purchased cheaply, pocketing the difference. Here’s how the game works:
At one point, while the stable coin was in free fall, Binance halted trading. Terraform Labs deployed $1.5 billion, half of it in bitcoin, and tried to bail out Terra, which got back up to 90 cents a coin on Tuesday before dropping to 38 cents on Thursday.
Terra CEO Do Kwon tweeted that he was “deploying more capital,” then there was mostly silence until a Wednesday-morning thread took on a more formal tone and ended with a promise that Terra would “return.” In the meantime, Bitcoin has plunged more than 29% in the last seven days and on Thursday dropped below $26,000 to trade at its lowest level since late Dec. 2020. Tether, the world’s largest stable coin, also fell below its $1 peg on Thursday amid a broader panic in cryptocurrency markets.
The carnage is severe enough to prompt Treasury secretary Janet Yellen to weigh to call for more federal regulation on stable coins. The crypto community seems to believe the government will be forced to crack down at any moment.
The lesson then is algorithmic stable coin mathematics at Terra volumes isn’t robust enough to orchestrated volume operation. That does not bode well for other stable coins with lower trading volumes.
