The recent tightening of monetary policy has led to a massive slump in several financial markets, including crypto assets, which lost nearly $1 trillion in market capitalization in just one week. Extreme market volatility triggered the disintegration of the Terra ecosystem. TeraUSD (UST), a dollar-pegged stablecoin, and its sister token Luna fell and delisted, smothering investors with billions in losses and accelerating the rubble of other cryptocurrencies. This debacle debunks tall claims of an innovative crypto-financial ecosystem believed to be immune to traditional finance (TradeFi) bank runs. Stablecoins, a breed of cryptocurrencies touted for their perceived stability, weakened during the week ending May 13, 2022, showing how things can go horribly wrong. The algorithmic stablecoin UST lost its dollar peg, collapsed, and wiped out nearly $50 billion in market cap. The collapse of the Terra ecosystem raises urgent questions about novel crypto assets and the robustness of the regulatory framework surrounding it.
What are stable coins?
Stablecoins are digital currencies pegged to a reference price to provide stable prices and purchasing power. These coins serve as a medium of exchange on crypto exchanges and decentralized finance (DeFi) liquidity pools. Most outstanding stablecoins are broadcast on public blockchains, such as Ethereum, Binance, Polygon, etc., and are USD-pegged. However, they can also be pegged to other fiat currencies, baskets of currencies, other cryptocurrencies, or commodities such as gold.
custodial stable coins Trusts are required in a third party and are issued by intermediaries, who act as custodians of the reserve assets. These intermediaries offer 1-for-1 redemption of stablecoins for US dollars or other fiat currencies. The major US dollar-based custodial stablecoins are Tether (USDT), Binance (BUSD), Circle (USDC), and TrueUSD (TUSD). These US dollar-pegged stablecoins are over collateral, and the peg is hedged through US dollar asset reserves, i.e. bank deposits, treasury bills, commercial paper, etc.
non-custodial stablecoins Replace trust with new economic systems. These stablecoins are backed by overcollateralized cryptocurrencies and/or smart contracts. Deposited legal assets are never held by any intermediary or third party. Defending fiat pegs to non-custodial stablecoins is accomplished by two mechanisms. The collateral system uses crypto-asset reserves to maintain the peg. The algorithmic mechanism uses financial engineering to protect the peg by buying or selling stablecoins against the respective governance crypto tokens. Examples of non-custodial algorithmic stablecoins include TeraUSD (UST), Magic Internet Money (MIM), Frax (FRX), and Neutrino-USD (USDN). MakerDAO (DAI) is an example of a non-custodial overcollateralized stablecoin.
Why are stablecoins so popular?
Investors prefer to buy cryptocurrency assets such as bitcoin, ether and more in order to maintain stable pricing and purchasing power. Stablecoin deposits offer higher yields than those available on fiat deposits, making them an attractive income-generating asset class. Additionally, stablecoins are cryptographically secure, enabling peer-to-peer financial transactions that are settled near-instant and 24-hour-a-day / 7-day-week / 365-day-a-year markets allow.
The Terra Economy primarily consisted of two token pools: one for the stablecoin UST and the other for LUNA. The UST-dollar peg was maintained by buying or selling the UST against the LUNA. If UST rose above the peg, the protocol gave impetus and traders were expected to mint UST as needed and burn Luna until UST dropped to $1; Increased UST supply will put downward pressure on its price. If UST fell below the peg, the protocol gave impetus and expected traders to do the opposite; Burn UST and mint LUNA continuously until UST increases to $1; The reduction in UST supply will put upward pressure on its price.
UST can also be traded with other stable coins on various crypto-exchanges and DeFi liquidity pools, which contributes to the stability of the dollar peg.
Terra Ecosystem’s Achilles Heel was Anchor Protocol – a savings, lending and borrowing sister platform that promised a 20% Annual Percentage Yield (APY) only on UST staking/deposit, not Tether’s USDT, Circle’s USDC Like on other stablecoins. Or Maker’s DAI. Anchor’s attractive yield, especially on the UST, created a frenzied demand, leading to a sharp increase in the number of USTs in circulation. Wrapped up as a dollar-like asset, UST was primarily bought and deposited into Anchor to earn a 20% yield. In November 2021, UST’s market cap was a mere $2.73 billion, reaching a peak of about $18 billion in May 2022. During the same time, the price of LUNA also doubled. Anchor was home to $14 billion, 75% of UST’s entire circulating supply of $18 billion.
Anchor’s 20% APY Greed – Creating A Ponzi Scheme?
Crypto protocols that offer high returns on deposits generate income by further lending the deposited assets and giving investors a portion of the interest earned. However, Anchor Protocol was probably not generating enough income to pay the 20% APY payment as promised. Anchor Lending received only a 10% annual percentage rate (APR) on their extended loans. Anchor potentially generated additional income on the borrower’s down payment collateral, which likely contributed to reducing its payment obligations. Anchor encouraged borrowers to borrow UST by paying 7% APY in the native Anchor Protocol’s Governance Token (ANC), reducing its net inflows.
Anchor’s relationship with UST can be viewed as a simple mechanism to create demand for a fledgling stablecoin or as a hidden Ponzi scheme to lure money seeking yield. With a juicy 20% APY wrapper on assets marketed as a US dollar proxy, UST may have attracted even investors who generally avoid volatile crypto markets.
In February 2022, Do Kwon, the founder of TerraForm Labs (LINK) and the face of Terra, added $450 million to reserves, raising concerns from outsiders. Beginning in 2022, Do Kwon was also buying Bitcoins to increase reserves.
The payment outflow of 20% on UST share/deposit probably exceeded the accrued inflow on UST borrowings, creating systemic outflows and reserve deficit.
Terra Fall: Market Volatility, UST Size, APY Attraction of Anchor, and Algorithmic PEG
The collapse of the Terra ecosystem was catalyzed by a series of extreme volatility, the volatility of the crypto markets, the breakdown of the UST peg, and large withdrawals from Anchor. With large withdrawals, UST was being sold to trade for other stable coins (backed by traditional assets) through various DeFi liquidity pools.
When UST started to lose its peg and traders wanted to exit UST, they had two options.
1) Trade the UST-LUNA Burn Mint algorithm within the Terra ecosystem.
2) Trade discounted UST with alternative stablecoins (USDC, BUSD, ..etc) in DeFi’s Deep Liquidity Pool.
When UST dipped slightly below $0.02 during the week of May 9, 2022, traders began flipping UST for another stablecoin, i.e. Tether’s USDT or Circle’s USDC. Eventually, the specific liquidity pool that allowed these trades became imbalanced; It now has far more USTs than other stablecoins. To correct course, the pool began offering discounted UST to arbitrageurs in the hopes of doing the opposite trade to rebalance the pool, which was not happening. When the selling pressure on UST continued to mount, it lost its $1.00 peg and started falling uncontrollably. When traders were unwilling to buy them, UST and LUNA both went into a death spiral, lost confidence in the Terra ecosystem, and dried up UST liquidity in the DeFi pool. Once UST lost counterparty stablecoins to trade, it lost the pricing mechanism – leading to a market failure. Both UST and LUNA were delisted from all exchanges. Ironically, prior to the recession, UST was the third largest stablecoin by total market capitalization after only Tether and USD Coin.
The surprise crash of the Terra ecosystem, along with its stablecoin UST and sister token LUNA, resulted in the failure of the algorithmic stablecoin market to vaporize billions of dollars. The Terra LUNA/UST fallout was a wake-up call for everyone to recognize the risks inherent with each and every stable currency, and in some, much more than others. These developments also raise questions about the robustness and long-term viability of algorithmic stablecoins. Many fear that a crack in the one-to-one peg of US dollar-backed stablecoins could lead to cross-margin selloffs in other asset classes and could have serious repercussions for traditional financial markets and the crypto-sector. Following this bloodshed, regulators may decide to bring stablecoins within the ambit of electronic payments regulations in order to mitigate the systemic risks hidden from stablecoin markets. Michele Triana, CEO of MeanFi, said, “Central Bank Digital Currency (CBDC) backed USD cannot come fast enough to crypto. If someone wants to deposit their trust in US dollars, the only entity they can trust is Should, that’s the US Federal Reserve. To all of them “a decentralized world needs a decentralized currency,” I say, yes, that’s bitcoin.
Stable crypto assets are a much needed building block for bridging Tradefi and DeFi. Stablecoins are a new class of innovative financial assets in their infancy that have the potential to revolutionize finance and drive adoption far beyond their current use in the cryptocurrency markets. Like many technological innovations that experienced early-stage shock before they started, it can be too premature to write an obituary for this class of crypto assets.