Speculation that the collapse of one of the biggest experiments in decentralized finance could bring about the death of crypto appears to have been overblown. If Terra's implosion had happened after a few more months of growth, the resultant market impact might have created a DeFi version of 2008 — instead, high-profile algorithmic stablecoins may end up being the main casualty.
In a tumble starting on May 9, Terraform Labs' TerraUSD — a token that primarily uses algorithms, rather than collateral, to adjust its supply and maintain a 1-to-1 peg with the US dollar — and its digital coin counterpart Luna lost almost all their value, while activity on the underlying Terra blockchain was twice suspended. A month after reaching a record of $119, the price of Luna now trades at near zero, while UST is stuck around 20 cents.
The meltdown sparked crypto price declines across the board; they later stabilized and recovered somewhat, but not without knocking some $300 billion or so off of the sector's trillion-dollar total market value. Most significantly, it caused wobbles in even the largest collateralized stablecoins, which back their peg with dollar and dollar-equivalent assets — though they too returned to business as usual by the end of the week.
Stablecoins are a vital part of crypto because they are used by traders as a means of retaining value without leaving the digital asset ecosystem. Investors turn to them as a safe haven during periods of volatility, or even simply as a means of digital payment. Now, questions remain on whether the unique mechanism behind TerraUSD might be entering retirement, at least for use by projects that get too big to fail.
“I wouldn't be surprised if this is the end of algorithmic stablecoins,” said Hilary Allen, professor of law at American University. “DeFi can't work without stablecoins, really. A lack of trust in stablecoins would be catastrophic for the DeFi ecosystem.”
Prior to losing its peg on May 8, TerraUSD had a total market value of around $18.6 billion — dwarfed in size by its collateralized rivals Tether and USDC, at $83.2 billion and $48.7 billion, respectively, according to data from CoinMarketCap. That kept its collapse from causing lasting widespread contagion, but any later, and it might have been a different story.
Price of Failure
As the Terra ecosystem grew in popularity, its co-founder Do Kwon said he wanted to build a reserve that might shore up UST in times of extreme stress. He established the Luna Foundation Guard, an organization aimed at keeping UST stable, which would look after a pile of Bitcoin he was slowly accumulating to act as collateral for UST. Meanwhile, developers continued to build apps on its blockchain, investors bet on its future and some crypto luminaries irrevocably tied themselves to the project.
Between January and March, the LFG bought $3.5 billion of Bitcoin, according to blockchain forensics firm Elliptic. In media interviews in March, Kwon said he planned to increase the pile to $10 billion by the third quarter of this year. The theory was that if TerraUSD unwound, the firm could deploy its existing Bitcoin supply to try and stabilize the selloff — though it may have required much more capital to save it.
Had the LFG's hoard already reached that $10 billion figure, the de-peg might have not been so brutal to markets — but that amount of Bitcoin hitting exchanges in quick succession would have triggered shockwaves throughout the sector. In calmer periods, such as the few days before Terra broke its peg, Bitcoin recorded an average of around $30 billion in daily trading volume — making Kwon's stockpile about a third of the entire market if dumped in one go.
“The reason why I want to get to $10 billion is that besides Satoshi, we will be the largest single holder of Bitcoin in the world,” Kwon said in an interview with crypto YouTube channel Fungible Times in March, referring to the wealth of Bitcoin's pseudonymous creator which has never been moved or traded. A video of the interview, seen by Bloomberg, was later removed on Friday following Terra's collapse.
“Then in that case, within the crypto industry, the failure of UST is equivalent to the failure of crypto itself,” Kwon added.
Even with some reserves added in as a backstop, the algorithmic model that governs UST is dependent on a combination of software programs, trader incentives and swaps with Luna to maintain its value. That's in comparison to collateralized stablecoins such as Tether, USDC and Binance's Binance USD, which rely on being able to redeem tokens from a reserve of fiat currency. In the case of Tether, the quality of those assets has previously been called into question — but during the instability caused by Terra, helped the token to avoid the same fate.
“Really we shouldn't use the same word for all of these things,” said Sam Bankman-Fried, chief executive of crypto exchange FTX, in a tweet on Thursday. “What we call ‘algorithmic stablecoins' aren't really stable in the same way that fiat backed stablecoins are. They're more like structured products, and they need upside if they want to justify the risk.”
The design flaw: minting coins (printing money) does not create value, it just dilutes the existing coin holders.— CZ 🔶 Binance (@cz_binance) May 13, 2022
Incentives doesn't create value. It is just a bootstrap mechanism.
Build products people use.
As the dust settles, broader consequences of Terra's downfall include heightened scrutiny of the entire stablecoin sector by regulators, who had already viewed tokens like Tether's as a potential systemic risk. Treasury Secretary Janet Yellen said on Thursday that the incident shows the dangers of private stablecoins, which while unregulated, can present the same kind of risks as bank runs.
“A stablecoin should be able to live up to its name,” said Denelle Dixon, chief executive of the Stellar Development Foundation, which supports the Stellar crypto network and USDC. “What we've seen this week has proved why it's essential to distinguish and define what is genuinely a stablecoin from what is not.”
Reeve Collins, co-founder and former CEO of Tether which operates its own asset-backed stablecoin, said Terra's collapse was part of crypto's natural order, using market corrections to wipe away the froth.
“The beauty of the bull market is it attracts the crazies, it attracts all the money and attracts the smart people into the market,” said Collins. who now acts as co-founder of NFT platform BlockV, in an interview. “Without the bull market, we wouldn't get the attention and the brains into the space. And without the bear market, we wouldn't really, you know, clean out the crowd.”