The collapse of the largest algo stablecoin, UST, rippled across the crypto ecosystem as both retail and institutional investors liquidated positions and off-ramped their stablecoins to fiat, triggering a plunge in total DeFi TVL and even leading to temporary depegs in collateralized stablecoins.
The magnitude of the UST blowup had attracted a tremendous amount of media coverage, from Twitter to TradFi reporters. As many were trying to catch up on what had happened, many were also touting “I told you so” as the inherent fragilities of UST’s design were widely published and discussed in the past year. All said and done, it is certain that UST will go down in the history books, hopefully as a learning lesson for future projects. This article will offer our take on what happened, what now, and what’s next for Terra ecosystem, DeFi space, as well as the entire crypto industry.
On 8 May 2022, UST momentarily depegged to $0.972. In anticipation of the newly launched Curve 4pool, the Luna Foundation Guard (LFG) removed $150M from the UST+3pool. During that window, $350M from an anonymous wallet was used to drain the remaining Curve liquidity. LFG started selling its BTC to defend the peg, causing downward pressure on BTC amidst macro headwinds. With the Curve liquidity drained, another $650M of UST was dumped on centralized exchanges, causing UST to fall to $0.60.
The further decline in UST was sparked by panic and fear as Anchor users started running for the hills, a full-on bank run ensued. With billions of funds flowing out, UST dived, trading as low as $0.25 on May 11th. LFG’s attempts to restore the peg were futile, as LUNA was forced into a hyperinflationary cycle to meet redemptions while UST continued its descent into oblivion. LUNA’s quickly vanishing market cap deemed the vast UST outstanding as bad debt – with the de-facto buyer of last resort LFG out of ammo.
History Does Not Repeat Itself, but It Often Rhymes
The debacle of Terra USD may come as a surprise to many, especially those new to the crypto scene. However, algo stablecoins have long existed before Terra rose to fame. Many of these algo stablecoins adopted similar ‘Seigniorage’ models, which burn an equivalent value of the native token for every stablecoin minted. Despite early signs of success and adoption, most of these algo stablecoins ended up with the same fate as UST.
The Iron Finance Fallout
“Algorithmic stablecoins are inherently fragile. These uncollateralized digital assets, which attempt to peg the price of a reference asset using financial engineering, algorithms, and market incentives, are not stable at all but exist in a state of perpetual vulnerability.”
Excerpt from Wake Forest L. Rev.
In June 2021, Iron Finance experienced “the world’s first large-scale crypto bank run”. The protocol failed in a catastrophic fashion, wiping out close to $2 billion.
Iron Finance unraveled when its governance token took a hit in the DeFi markets. The large-scale sell-off sparked a negative feedback loop as holders flocked to redeem their IRON1 tokens and sell their TITAN, which in turn, caused more TITAN holders to sell. The cascading free-fall caused the IRON token to lose its peg, which in turn, led to a “death spiral”. At some point, the price of TITAN was virtually zero, and Iron Finance paused redemptions of IRON. In retrospect, IRON was designed on the assumption that TITAN can fully absorb the volatility of IRON.
Here we see that Iron Finance, alongside other algo stablecoin projects such as Basis Cash and Empty Set Dollar, did not manage to cross the chasm due to mechanical flaws in the tokenomics design. The surprise this time was the speed and magnitude of its demise, despite the ecosystem’s immense scale, widespread adoption, and the series of market maker bailouts.
Forex Markets Have Seen This Chapter a Few Times
Depegging and bank runs are not limited to the DeFi space as Forex markets are all too familiar with major crashes and depegs due to exogenous factors. A classic anecdote is George Soros’s bet against the Bank of England (BoE) between 1991-1992. George Soros took notice of the high inflation that the United Kingdom was experiencing and the lack of BoE’s reserve to defend the currency, and began to short the pound. Soros’ action caused a chain reaction, intensifying sell pressure on Sterling to a point that the BoE was unable to defend against the selling pressure and forced to leave the European Exchange Rate Mechanism (ERM) to let the markets devalue its currency.
Likewise, in 2015, the Swiss National Bank announced that the Swiss Franc would stop its peg to the Euro. The Swiss Franc immediately jumped 20%. Many institutional traders, retail investors, and even exchanges were left holding their bags, amassing huge losses. If this type of systemic risk can exist in mature TradFi markets with significantly deeper liquidity, it’s a tall order for DeFi protocols to attempt at creating a successfully pegged stablecoin.
The Fallout: After Effects of This Event
Long-Term Ramifications of Terra’s Failure
The collapse of well-known stablecoin projects has made the danger of a “death spiral” well known while Terra’s collapse has sealed this in the history books of crypto. The debacle of Terra may spell the end of seigniorage share algo stablecoins.
As new stablecoin projects such as USDD (Tron) attempt to make their mark with attractive yields that rival that of Anchor on Terra, investors will be warier and take extra precautions before putting their savings into it. What guarantees are there that such projects can retain their peg in times of turbulence if the once largest algo stablecoin could not? We believe that a decentralized economy needs a decentralized stablecoin and that algo stablecoins can be one of many solutions. This black swan event clearly showed everyone that if algo stablecoins are to live on, major changes have to be made.
The UST saga made it obvious that we still do not have an answer to the trilemma presented before us. At its core, UST failed due to centralization and capital inefficiency. With the LFG promising stockpile of Bitcoin meant to stabilize UST, almost everything depended on LFG and its decision of when to sell their Bitcoin to restore the peg.
This reliance proved disastrous as the peg was not maintained despite LFG selling most of its Bitcoin holdings. As UST grew, there was a need for LFG to purchase more Bitcoin, making such a model impractical and capital inefficient in nature (of course, if LUNA rallies at the same time, then the opera will continue).
Other efforts to bullet-proof UST, including making UST cross-chain and LFG’s LUNA swap with AVAX, also failed to make LUNA-UST too-big-to-fail. The fall of UST, despite its integration with other DeFi projects, had likely proven that the crypto world lacks truly concerted actors.
Given time, LUNA-UST could have followed Do Kwon and LFG’s plan and integrated with more projects to become more systematically important than it was before the collapse. Were it allowed to reach such a level, a debatable question surfaces; when UST faces depegging risks, would the community have to team up and save it just like AIG’s bailout, or cut it loose like Lehman? To some extent, DeFi communities are lucky to have dodged such a scenario – a truly integrated UST might have claimed even more ecosystems as collateral damage during a depeg, and risk the destruction of the DeFi industry.
Terra’s failure has reignited calls for regulation, particularly in light of the billions of dollars lost by retail investors. After the events of UST’s depeg, regulators have stated that they will attempt to swiftly control the crypto industry, specifically in DeFi and stablecoins before it poses a systemic risk to the broader markets. In the UK, the British Treasury Department was quick to remind markets of its commitment to regulate stablecoins following the collapse of UST. US Treasury Secretary Janet Yellen also raised concerns about the UST collapse, citing the need for some form of stablecoin regulation. Additionally, South Korea is looking to hop on the regulatory bandwagon as well, citing the desire to explore some form of regulation in the space.
The growth-at-all-costs mentality that Terra adopted likely contributed to the demise of its ecosystem. Like every platform business out there, Terra’s blueprint was to jump-start adoption and multiply transaction volumes subsequently by creating critical mass for its users. Do Kwon’s UST printer, Anchor, exacerbated the LUNA/UST asset/liability mismatch. In the tweet, what Jordi brought up was that UST, seen as an “I owe you” (IOU) that converts to LUNA, was disproportionately printed without balancing on the other side with LUNA.
This is analogous to the growth playbook adopted by most crypto projects out there; magic money printing created by smart contracts that fuelled synthetic growth without actual value behind its disbursed rewards. Consequently, reward tokens that were quickly sold off by mercenary capital resulted in treating such rewards as IOUs to the token’s liquidity pool pairs. The token saw a boom phase where yields were high and price skyrocketed. What we do not see is that there is more dilution or IOUs being printed due to emissions as opposed to the amount of funds flowing into the protocol. With everyone deciding to take profit, many will exit only to realize that there aren’t enough assets/liquidity to pay off these IOUs. That is when the bloodbath comes in, and we see the declining chart that many are too well familiar with.
The UST crash might have been significant enough to cause distrust and overall disinterest in the DeFi industry. We see many projects unwinding across chains as DeFi TVL continues to dry up. As investors return to the drawing board, we foresee a rotation back into sustainable “DeFi 1.0” protocols which have operated longer. Like the dot-com bust, we could see bigger projects acquire smaller dApps to acquire market share at heavily discounted valuations. In addition, projects that rely on inflationary methods will be scrutinized, whereas we see projects with organic growth being prioritized as they generate real tangible demand. The prioritization of sustainability and on-chain failsafes over growth will be a key criterion moving forward. While this crash will set mainstream adoption back by a few years, the opportunity to emerge as a dominant force will be on projects who can innovate and build real value in the space.
A Look Into the Crystal Ball: The Future Stablecoin Landscape
The Best We Have Got
It goes without saying that the near future will see investors rotating back into centralized stablecoins that are fully backed by fiat and fiat equivalents. Despite a brief depeg of USDT on May 12th, redemptions/off-ramping from crypto to fiat on USDT/USDC remained largely smooth, which alleviated the market’s concern quickly.
Meanwhile, decentralized stablecoins like DAI that use an over-collateralized approach will likely be favored. These collateralized debt positions (CDP) have a built-in safety mechanism that guards against collateral price depreciation. For example, for a given collateralization ratio of 150%, every $1 of DAI minted requires $1.50 of ETH to be deposited. DAI also includes a stability fund that collects fees and will be used to keep the Maker system afloat in times of need. One critique of this approach is that overcollaterization is capital inefficient. However, such a design mechanism will always weather volatility better than the undercollateralized counterparts – you can’t have both sides of the coin.
A Whole New World for Algo Stablecoins?
[For more discussion on this topic, revisit Treehouse’s previous article dedicated to stablecoins]
Partially Collateralized Stablecoins
FRAX is the first stablecoin that introduced the combination of collateralized and algorithmic models. At the core of it, Frax relies on two assets: The FRAX stablecoin and the FXS governance utility token. The FRAX stablecoin was built to maintain a peg to $1 USD, while the FXS token was built to support the platform’s various functions.
The Frax minting and redeeming mechanism is the key to maintaining its peg to the US dollar. FRAX tokens can be minted by users who supply collateral tokens such as USDC or a combination of governance and collateral tokens. The proportions of each of these tokens are given by the collateral ratio. A 60% collateral ratio would mean that 1 FRAX can be minted with $0.60 USDC and $0.40 FXS. This mechanism is put in place to ensure price stability for the FRAX token, a key aspect of the stablecoin trilemma.
While there are risks associated with FRAX, as with any project in the blockchain space, the Frax experiment has shown to be extremely intriguing and inventive as it has done an astounding job in holding its peg so far.
Credit-Based Algo Stablecoins
Most algo stablecoins follow a seigniorage-based system, Beanstalk introduces the concept of a credit base stablecoin protocol that issues debt to maintain its peg. To summarize, when price falls below peg, stablecoin BEAN, supply is burned by issuing debt that is bought with BEAN, to be burned. The protocol mints BEAN to increase supply when price moves above its peg, debt is then paid back on a FIFO basis as the protocol mints BEAN.
By aiming to be a decentralized credit facility, the protocol builds trust as it continues to pay off its debt. Compared to the seigniorage approach, this type of algo stablecoin aims to remove the custodian aspect of converting stablecoin for native token. The whitepaper also claims that its aim is not to remain perfectly pegged but instead, “Beanstalk creates user confidence by consistently crossing the price of 1 BEAN over its value peg with increased frequency and less volatility.”
In the stablecoin trilemma, we see that Beanstalk consciously forgoes perfect stability for decentralization and capital efficiency so as to build trust with its users. Being the first of its kind, time will tell if Beanstalk brings us a step closer to a better algo stablecoin framework.
Algo Stablecoin Consortium: Basel Accord 3.0
A decentralized stablecoin is required for a decentralized economy. One conceivable road ahead, according to @TaschaLabs, is to establish an industry standard for algo stablecoins. A group of industry leaders or a DAO could create a set of standards and metrics for future algo stablecoin projects to follow. While not necessary to adhere to, projects that follow such standards and are verified would build trust among users. Ideally, the framework for all algo stablecoins would include risk measures, collateral custodial safeguards, reporting transparency, as well as a defined documentation explaining and identifying algo stablecoin varieties.
Furthermore, having an industry standard to follow could encourage more algo stablecoin projects to come to the fold, thereby creating a market of multiple mid-cap algo stablecoins coexisting within the broader blockchain ecosystem. This reduces the risk of a domino effect scenario, in which the failure of one algo stablecoin can have a negative repercussion on the entire ecosystem.
Current Proposals on Terra Ecosystem’s Next Step
Following the events that have taken place over the course of the last few weeks, various proposals have been put forward to chart the path for the LUNA ecosystem as a whole. Three proposals have been discussed in great detail across the crypto community on Twitter and the Terra governance portal page.
Proposal 1 by “FatMan”
Proposal 1 seems to have caught the eyes of most retail investors as well as other high-profile individuals. This is because of the proposal’s focus on making UST holders whole. “FatMan” is working with other members in the community to suggest changes to Do Kwon’s proposal.
Proposal 2 by Do Kwon
Proposal 2 was the initial proposal laid out by Do Kwon in his “revival plan”. This proposal focussed on the preservation of the Terra ecosystem and the fact that UST has lost too much of its value to be worth preserving. Do Kwon has since released another proposal, which shares the same core idea of his initial proposal, that Terra is more than just UST.
Proposal 3 by Do Kwon
Proposal 3 proposes a fork of LUNA. According to Do Kwon, focus should be directed towards developing a new chain with a new token as opposed to trying to get the current chain back on track. This does not bode well with the community. As it stands 90% of the community are against the idea of forking the current chain into the new Terra chain.
The Terra USD debacle demonstrated that financial product innovation carries dangers. Financial markets have also shown us in the past that the perplexing assortment of financial alchemy frequently results in devastating outcomes. Recency bias is a strong human condition that leads us to over-extrapolate the present. The failure to imagine the unexpected may warrant excess faith that tomorrow will unfold as today has. Will the quest for truly decentralized stablecoins halt here? Or will this be a valuable learning experience for the entire blockchain ecosystem to develop an even more robust and antifragile decentralized algorithmic stablecoin? The latter, we believe, is the most likely of the two. The markets will always test the fragility of our system, and this will be a watershed moment for the entire cryptosphere. Moving forward, we should expect to see more innovations with a long-term mindset for sustainability and stability.
1 Iron Finance’s algo stablecoin, “IRON”, adopted an “over-collateralized and soft-pegged” mechanism. Each IRON stablecoin was minted through a process that locked up 75% of its value in Circle USD (USDC) and the remaining 25% through TITAN – Iron Finance’s governance token. Similar to existing algo stablecoins, the protocol relied on a market-driven “arbitrage” opportunity between the IRON stablecoin and the TITAN governance token. If IRON went below $1, an arbitrageur could purchase IRON on the secondary market and redeem it for $1 of combined USDC and TITAN.
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