Recent monetary policy tightenings have triggered steep declines in many financial markets, including crypto assets which have lost almost $1 trillion in market capitalization in just one week. Extreme market volatility triggered the disintegration of the Terra ecosystem. TerraUSD (UST), a dollar-pegged stablecoin, and its sister token LUNA plummeted and delisted, saddling investors with billions in losses and accelerating the wreckage of other cryptocurrencies. This debacle debunked tall claims of an innovative crypto-financial ecosystem supposedly immune to traditional finance (TradeFi) bank runs. Stablecoins, a breed of cryptocurrencies touted for their purported stability, became vulnerable during the week ending May 13th, 2022, showing a glimpse of how things can go horribly wrong. The algorithmic stablecoin UST lost its dollar peg, collapsed, and wiped out nearly $50 billion in market value. The Terra ecosystem collapse raises urgent questions regarding the robustness of novel crypto assets and the surrounding regulatory framework.
What are Stablecoins?
Stablecoins are digital currencies pegged to a reference value to provide stable prices and purchasing power. These coins serve as a medium of exchange on Crypto Exchanges and Decentralized Finance (DeFi) liquidity pools. The majority of outstanding stablecoins circulate on public blockchains, such as Ethereum, Binance, Polygon, etc., and are US dollar-pegged. However, they can also be pegged to other fiat currencies, baskets of currencies, other cryptocurrencies, or commodities such as gold.
Custodial Stablecoins require trust in a third party and are issued by intermediaries, who serve as custodians of reserve assets. These intermediaries offer 1-for-1 redemption of stablecoins for US dollars or other fiat currencies. Major US dollar-pegged custodial stablecoin are Tether (USDT), Binance (BUSD), Circle (USDC), and TrueUSD (TUSD). These US dollar-pegged stablecoins are over collateralized, and the peg is defended via US dollar asset reserves, i.e., bank deposits, treasury bills, commercial paper, etc.
Noncustodial Stablecoins replace trust with innovative economic mechanisms. These stablecoins are backed by overcollateralized cryptocurrency and/or smart contracts. The deposited fiat assets are never custodied with an intermediary or third party. The fiat pegs for noncustodial stablecoins are defended by two mechanisms. Collateralized mechanisms use crypto-asset reserves to maintain the peg. Algorithmic mechanisms use financial engineering to defend the peg by buying or selling the stablecoin against an associated governance crypto token. Noncustodial algorithmic stablecoin examples include terraUSD (UST), magic internet money (MIM), frax (FRAX), and neutrino-usd (USDN). MakerDAO’s (DAI) is an example of a noncustodial overcollateralized stablecoin.
Why are Stablecoins so popular?
Investors prefer to buy crypto assets such as bitcoin, ether, and more, using fiat-pegged stablecoins 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 settle near-instantaneously and allow 24-hours-a-day/7- days-a-week/365-days-a-year markets.
Terra economy primarily consisted of two token pools: one for the stablecoin UST and another for LUNA. The UST-dollar peg was maintained by either buying or selling UST against LUNA. If UST rose above the peg, the protocol incentivized and expected traders to mint UST as needed and burn LUNA until UST dropped to $1; the increased UST supply would put downward pressure on its price. If UST fell below the peg, the protocol incentivized and expected traders to do the opposite; continuously burn UST and mint LUNA until UST rose to $1; the decreased UST supply would put upward pressure on its price.
UST could also be traded with other stablecoins on various crypto-exchanges and Defi liquidity pools, contributing to the stability of the dollar peg.
The Achilles heel of the Terra ecosystem was the Anchor Protocol – a saving, lending, and borrowing sister platform that promised a 20% annual percentage yield (APY) on UST staking/deposits only and not on other stablecoins like Tether’s USDT, Circle’s USDC, or Maker’s DAI. Anchor’s enticing yield exclusively on USTs created a frenzied demand, leading to a blazing expansion of the number of USTs in circulation. Wrapped as a dollar-like asset, UST was mainly purchased and deposited into Anchor to earn the 20% yield. In November 2021, UST’s market cap was a mere $2.73 billion, which peaked at around $18 billion in May 2022. During the same time, LUNA also doubled in price. Anchor was home to $14 billion, 75% of UST’s entire circulating supply of $18 billion.
Anchor’s 20% APY Lure – Making Of A Ponzi Scheme?
Crypto protocols offering high yields on deposits generate income by further loaning out the deposited assets and paying investors a chunk of the earned interest. However, Anchor protocol was probably not generating enough income to pay its promised 20% APY payouts. Anchor borrows received only a 10% Annual Percentage Rate (APR) on their extended loans. Anchor potentially generated additional income on borrower down payment collateral, which possibly contributed towards mitigating its payout obligations. Anchor also incentivized borrowers by paying them 7% APY in native Anchor Protocol’s governance token (ANC) for borrowing USTs, reducing its net inflows.
Anchor’s relationship with UST could be judged as an ingenious mechanism to manufacture demand for a fledgling stablecoin or a veiled Ponzi scheme to lure yield-seeking money. Baited with a juicy 20% APY wrapper on an asset marketed as a US dollar proxy, UST even might have attracted investors who usually eschew volatile crypto markets.
In February 2022, Do Kwon, the founder of Terraform Labs (link) and the face of Terra, added $450 million into the reserves raising concerns from outsiders. Since the beginning of 2022, Do Kwon was also buying Bitcoins to shore up reserves.
The 20% payout outflow on the UST staking/deposit was probably higher than the earned inflow on the UST borrows, creating a systemic outflow and reserve deficit
Terra Collapse: Market volatility, UST size, Anchor’s APY lure, and the Algorithmic peg
Terra ecosystem collapse was catalyzed by extreme volatility, destabilization of crypto markets, breaking of the UST peg, and a series of large withdrawals from Anchor. In tandem with the big withdrawals, UST was also being sold to trade for other stablecoins (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 choices.
1) Trade the UST-LUNA burn mint algorithm within the Terra ecosystem.
2) Trade the discounted UST with alternative stablecoin (USDC, BUSD, ..etc.) at DeFi’s deep liquidity pools.
When UST depegged by a little less than $0.02 during the week of May 9th, 2022, traders began flipping UST for any other stablecoin, i.e., Tether’s USDT or Circle’s USDC. Eventually, the specific liquidity pool that allowed these trades became unbalanced; it now had far more USTs than other stablecoins. To correct course, the pool then began to offer discounted USTs in hopes of getting arbitrageurs make the opposite trade to rebalance the pool, which was not happening. When sell pressure on UST continued to rise, it lost its $1.00 peg and started to drop uncontrollably. When traders weren’t willing to buy them, both UST and LUNA went into a death spiral, confidence in the terra ecosystem nosedived, and the UST liquidity at DeFi pools dried up. Once UST lost the counterparty stablecoins for trading, it lost the pricing mechanism – causing a market failure. Both UST and LUNA were delisted from all exchanges. Ironically, before the bearish run, UST was the third-largest stablecoin by total market capitalization trailing only Tether and USD Coin.
The stunning crash of the Terra ecosystem, along with its stablecoin UST and sister token LUNA, resulted in the algorithmic stable coin market failure that vaporized billions of dollars. The Terra LUNA/UST fallout was a wake-up call for everyone to recognize the inherent risks with every single stablecoin and, in some, a lot more than others. These events also raise questions about the robustness and long-term viability of algorithmic stablecoins. Many fear a crack in one-to-one pegs of the US dollar-backed stablecoins could lead to cross-margin selling in other asset classes and have severe repercussions in traditional financial markets and the crypto-sphere. In the aftermath of this bloodbath, to reduce hidden systemic risks from the stablecoin markets, regulators may decide to bring stablecoins within the scope of electronic payments regulations. Michel Triana, CEO MeanFi states, “The Central Bank Digital Currency (CBDC) backed USD cannot come fast enough to crypto. If someone wants to deposit their trust in the US Dollar, the only entity they should feel comfortable trusting is the US Federal Reserve. To all of those preaching “a decentralized world needs a decentralized currency,” I say, yeah, that’s what Bitcoin is”
Stable crypto assets are a much-needed building block to bridge TradFi and DeFi. Stablecoins are a new class of innovative financial assets in their infancy that have the potential to revolutionize finance and find adoption much beyond their current usage in cryptocurrency markets. Like many technological innovations which experienced early-stage setbacks before taking off, it may be too premature to write an obituary for this class of crypto assets.