Terra And The Freestanding Algorithmic Stablecoin

A successful algorithmic stablecoin is the Internet equivalent of a freestanding dollar, a currency cut off from its peg to the gold standard. Recent advances in technology and cryptography make the idea sound deceptively simple. Practical implementation, however, remains elusive. Many attempts at creating algorithmic stablecoins have failed in the past. TerraUSD (UST) is the latest example of one such coin teetering on the brink of collapse.

The stablecoin lost its peg to the US dollar this week after investors sold off their holdings in the cryptocurrency. The cascade of events that led to Terra’s price collapse illustrate fundamental problems in the attempts to design a freestanding algorithmic stablecoin in a crypto ecosystem with thin liquidity and few use cases.

A Weekend Tumble

Even as Terra’s price began its descent over the weekend, the price of Luna – the underlying miner token responsible for maintaining its peg – also crashed. The result was a ‘death spiral’ of prices for both tokens that resulted in Terra trading for as low $0.61 to the dollar at one point of time and a sharp 99% drop in value for Luna.

Reports have ascribed the plummeting prices to ‘weak sentiment’. But that is oversimplification.

Terra relied on an unproven token as a backstop. Terraform labs, the outfit behind Terra, created Luna – a token native to the Terra blockchain – as a counter to the stablecoin. Luna is minted or burned [removed from circulation] based on Terra’s price movements. Thus, when Terra’s price decreases, Luna’s supply increases to absorb the volatility and vice versa.

During the events that unfolded in the past week, Luna’s supply should have increased. But it fell by 447,515 coins. Blockchain data shows that Luna supply has increased by 80 million in the last four days. But it was not enough to arrest the 99% slide in Luna’s price by this morning as investors lost confidence in its ability to bolster Terra’s peg.

What Use Case?

Their fears are not unfounded. For all their faults, fiat currencies have verified use cases. They can function as a medium for daily transactions and a store of value. These use cases generate demand for the asset class.

Beyond lending and trading, there are few uses for digital coins in the current crypto ecosystem. Crypto use in daily transactions remains a pipe dream.

Terra’s utility is mainly concentrated in an ecosystem created by Terraform Labs. According to some estimates, an astounding 74% of demand for Terra comes from the Anchor protocol, a Terraform Labs lending platform that offers interest rates as high as 20% on the stablecoin. The platform also held 53% of all UST in circulation as of February 2022.  

When asked about the specifics of a 20% yield, Terra co-founder Do Kwon was unable to provide a satisfactory answer and made vague references to a ‘money market’ on Anchor’s platform. Analysts say a 20% yield is unsustainable in the long run. “…there is far more demand for the 20% yields from depositors than there is demand from borrowers for UST at the moment,” wrote Martin Gaspar, analyst at Cross Tower, in February.

The Search for A Reserve Asset

Meanwhile, attempts by the Luna Foundation Guard (LFG), an entity created to maintain the price peg, to diversify and extend its stablecoin’s reach beyond its own properties have been mixed. This is mainly because Luna lacks credibility outside the Terraform Labs universe. Terra co-founder Kwon told an interviewer that faith in Luna as collateral for Terra is a “lot less” on other chains.

LFG has shifted tracks to using Bitcoin as a reserve asset for Terra. The foundation is investing heavily in the cryptocurrency and co-founder Kwon has suggested that they are moving the stablecoin to a Bitcoin standard. While Bitcoin has found use as a store of value, its price remains volatile. That means the price of Terra is backstopped by assets that have volatile prices. An example is Aave, a token that has lost approximately 63% of its value from the beginning of this year.

[Incidentally, there is no mention of Bitcoin as a reserve asset in Terra’s whitepaper, which also states that “Bitcoin’s extreme price volatility is a major roadblock towards its adoption as a medium of exchange and store of value.”]

Of course, this is not the first time that a stablecoin is using another cryptocurrency as a reserve asset. MakerDAO’s Dai, which uses Ethereum’s Ether in its reserves, is an example. Ether’s volatility has created many crises in Dai’s peg, leading its backers to add Bitcoin to their mix. Terra is also likely set for a rough ride in the coming months. Meanwhile, the endgame for an algorithmic stablecoin, at least for now, seems to be a pegged asset and not a freestanding one.