Recent monetary policy tightenings have caused sharp declines in many financial markets, including crypto assets which have lost nearly $1 trillion of market capitalization in just one week. Extreme market volatility triggered the disintegration of the Terra ecosystem. TerraUSD (UST), one dollar-ankle stablecoin and its sister token LUNA plummeted and delisted, burdening investors with billions in losses and accelerating the sinking of other cryptocurrencies. This debacle has debunked major claims of an innovative crypto-financial ecosystem supposedly immune to traditional finance (TradeFi) banking race. Stablecoins, a breed of cryptocurrencies touted for their supposed stability, became vulnerable in the week ending May 13, 2022, showing a glimpse of how horribly wrong things can go. The UST algorithmic stablecoin lost its peg to the dollar, crashed and wiped out nearly $50 billion in market value. The collapse of the Terra ecosystem raises urgent questions regarding the robustness of new crypto assets and the surrounding regulatory framework.
What are Stablecoins?
Stable Coins are digital currencies pegged to a benchmark 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 stablecoins in circulation circulate on public blockchains, such as Ethereum, Binance, Polygon, etc., and are pegged to the US dollar. However, they can also be attached to other fiat currenciescurrency baskets, other cryptocurrencies or commodities such as gold.
Guard stablecoins require the trust of a third party and are issued by intermediaries, who serve as custodians of reserve assets. These intermediaries offer a 1-for-1 exchange of stablecoins for US dollars or other fiat currencies. The main stablecoins pegged to the US dollar are Tether (USDT), Binance (BUSD), Circle (USDC)and TrueUSD (TUSD). These US dollar-pegged stablecoins are over-collateralized and the peg is defended via pools of US dollar assets, i.e. bank deposits, treasury bills, commercial paper, etc. .
Noncustodial stablecoins replacing trust with innovative economic mechanisms. These stablecoins are backed by overcollateralized cryptocurrency and/or smart contracts. Deposited fiduciary assets are never held with an intermediary or third party. The fiat pegs for non-custodial stablecoins are defended by two mechanisms. Secured mechanisms use reserves of crypto-assets to maintain the peg. Algorithmic mechanisms use financial engineering to defend the peg by buying or selling the stablecoin for an associated governance crypto token. Examples of noncustodial algorithmic stablecoins include terraUSD (UST), magic money on the internet (MIM), Frax (FRAX)and neutrino-usd (USDN). MakerDAO (DAI) is an example of a noncustodial overcollateralized stablecoin.
Why are stablecoins so popular?
Investors prefer to buy crypto assets such as bitcoin, ether, etc., using fiat stablecoins to maintain stable prices and purchasing power. Stablecoin deposits offer higher returns than those available on fiat deposits, making it an attractive income-generating asset class. Additionally, stablecoins are cryptographically secure, enabling peer-to-peer financial transactions that settle almost instantly and enable 24/7/365 markets.
The Terra economy mainly consisted of two token pools: one for the UST stablecoin and another for LUNA. The peg to the US dollar was maintained by buying or selling UST against LUNA. If the UST rose above the peg, the protocol incentivized and expected traders to hit the UST as needed and burn LUNA until the UST fell to $1; increasing UST supply would put downward pressure on its price. If the UST fell below the peg, the protocol incentivized and expected traders to do the opposite; continuously burn UST and hit LUNA until UST reaches $1; decreasing 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 sister savings, lending and borrowing platform that promised a 20% Annual Percentage Yield (APY) on UST staking/deposits only and not other stablecoins like USDT from Tether, Circle’s USDC or Maker’s DAI. Anchor’s attractive yield exclusively on USTs has created frenzied demand, leading to a meteoric expansion in the number of USTs in circulation. Wrapped as a dollar-like asset, UST was mostly bought and deposited into Anchor to earn the 20% return. In November 2021, Market capitalization of UST was only $2.73 billion, which peaked at around $18 billion in May 2022. During the same period, LUNA also price doubled. 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?
Cryptographic protocols offering high returns on deposits generate income by lending more of the deposited assets and paying investors a portion of the interest earned. However, the Anchor Protocol was probably not generating enough revenue to pay its promised 20% APY payouts. Anchor Loans only received an annual percentage rate (APR) of 10% on their extended loans. Anchor potentially generated additional revenue on the borrower’s deposit guarantee, which may have helped ease its payment obligations. Anchor also incentivized borrowers by paying them 7% APY natively Anchor Protocol governance token (ANC) to borrow USTs, reducing its net inflows.
Anchor’s relationship with UST could be seen as an ingenious mechanism to create demand for a fledgling stablecoin or a veiled Ponzi scheme to lure in yield-seeking money. Baited with a juicy 20% APY wrap on an asset marketed as a US dollar proxy, UST might even have attracted investors who typically shy away from volatile crypto markets.
In February 2022, Do Kwon, the founder of Terraform Labs (link) and the face of Terra, added $450 million in reserves raising concerns from the outside. Since the beginning of 2022, Do Kwon had also been buying Bitcoins to shore up its reserves.
The 20% payout outflow on UST staking/deposit was likely higher than the inflow earned on UST borrowings, creating a systemic outflow and reserve shortfall
Terra Collapse: Market Volatility, UST Size, Anchor’s APY Lure, and Algorithmic Anchoring
The collapse of the Terra ecosystem was catalyzed by extreme volatility, the destabilization of the crypto markets, the breaking of the UST anchor, and a series of large Anchor withdrawals. Along with large withdrawals, UST was also being sold to be exchanged for other stablecoins (backed by traditional assets) through various DeFi liquidity pools.
When the UST started to lose its peg and traders wanted to exit the UST, they had two choices.
1) Redeem the UST-LUNA burn mint algorithm within the Terra ecosystem.
2) Trade discounted UST with alternative stablecoins (USDC, BUSD, ..etc.) in deep DeFi liquidity pools.
When the UST fell just under $0.02 during the week of May 9, 2022, traders started flipping the UST for any other stablecoin i.e. Tether’s USDT or Circle’s USDC. Eventually, the specific liquidity pool that enabled these transactions became unbalanced; it now had significantly more UST than other stablecoins. To correct this, the pool then started to offer USTs at a discount in the hope that arbitrageurs would make the opposite trade to rebalance the pool, which was not happening. As the selling pressure on the UST continued to build, it lost its peg at $1.00 and began to fall uncontrollably. When traders were unwilling to buy them, UST and LUNA entered a death spiral, confidence in the terra ecosystem plunged, and UST liquidity in DeFi pools dried up. Once the UST lost the counterpart stablecoins for the trade, it lost the pricing mechanism, which caused the market to fail. UST and LUNA have been delisted from all stock exchanges. Ironically, before the bear run, UST was the third largest stablecoin by total market cap, behind only Tether and USD Coin.
The staggering crash of the Terra ecosystem, along with its stablecoin UST and sister token LUNA, led to the algorithmic failure of the stablecoin market that vaporized billions of dollars. The Terra LUNA/UST fallout has been a wake-up call for everyone to recognize the risks inherent in every stablecoin and, in some, much more so than others. These events also raise questions about the robustness and long-term viability of algorithmic stablecoins. Many fear that a crack in the one-to-one pegs of the US dollar-backed stablecoins could lead to cross-margin selling in other asset classes and have serious repercussions for traditional financial markets and the crypto-sphere. In the aftermath of this bloodbath, to reduce the hidden systemic risks of stablecoin markets, regulators may decide to bring stablecoins into the scope of electronic payments regulation. Michel Triana, CEO AverageFi states,”The central bank’s digital currency (CBDC) USD supported can’t come fast enough for crypto. If anyone wants to deposit their trust in the US dollar, the only entity they should feel comfortable trusting is the US Federal Reserve. To everyone who preaches “a decentralized world needs decentralized currency”, I say, yes, that’s what Bitcoin is.
Stable crypto assets are an indispensable building block for linking TradFi and DeFi. Stablecoins are an innovative new class of financial assets in their infancy that have the potential to revolutionize finance and find adoption far beyond their current use in cryptocurrency markets. Like many technological innovations that experienced early-stage setbacks before taking off, it may be too premature to write an obituary for this crypto asset class.