DeFi 101: Algorithmic Stablecoins after LUNA Crash
Investors have long made peace with the volatility of speculative tokens, recognizing that boom-and-bust cycles are inherent to well-functioning markets. But what happens when the shock originates from an asset class that is, by its definition, supposed to ensure stability?
In our latest addition to the “DeFi 101” series, we look at the formative market crash of early May, explaining how TerraUSD (UST), an algorithmic stablecoin, lost its 1:1 parity with the US dollar, resulting in a $40bn wipeout that briefly brought the entire market down with it.
Stablecoins have been the mainstay of the crypto economy ever since the first of them was launched in 2014. Today, well-established stablecoins like Tether (USDT), USD Coin (USDC), and Binance USD (BUSD) continue to serve as entry points for new investors. They provide refuge to those who seek a momentary escape from high price volatility. They also remain instrumental in many staking and lending activities and are often utilized to facilitate trades and minimize fees on exchanges.
Nevertheless, despite being essential, they were never perfect. By design, most major stablecoins maintain a 1:1 peg to the US dollar thanks to their “over-collateralized” reserves of fiat currencies and other cash equivalent assets. Since these reserves have to remain liquid at all times, stability comes at the price of capital efficiency. And since reserves tend to be controlled by some centralized entity tasked with maintaining price stability, stablecoins also run counter to the DeFi ethos of full decentralization, not least because of the risks associated with the human factor.
Shaped in the spirit of DeFi
But what if stability measures could be baked directly into the self-executing smart contracts instead of relying on some centralized authority? What if, instead of hoarding vast liquid asset reserves, price volatility could be reduced dynamically by manipulating circulating supply and the behavior of market participants? And thus — from a curious mixture of ideology, mathematics, monetary economics, and technological progress in DeFi — an idea for a supposedly superior, algorithmic stablecoin was born.
Such algorithmic (think, “non-collateralized”) stablecoins were touted to drastically improve capital efficiency and lead to an overall greater degree of decentralization achieved through pre-programming of price stability measures. Many developers also believed to have stumbled upon a way to maintain a more stable parity with the US dollar. Instead of a simple rebasing mechanism — automatically burning tokens when the price drops below $1.00 and minting tokens when it surpasses $1.00 — some stablecoins would utilize the so-called “seigniorage” (or “two-coin”) architecture. The idea was to pair the algorithmic stablecoin with a ‘balancer’ token that would sponge up all of the market volatility.
That was the architecture behind the Terra blockchain, which ran the biggest algorithmic stablecoin platform prior to the crash in early May. TerraUSD (UST) stablecoin would maintain parity with the US dollar thanks to its algorithmic relationship with LUNA, Terra’s native currency. Since the protocol would always allow $1.00 of LUNA to be exchanged for 1 UST and vice versa, any deviation from the peg to the US dollar would open an arbitrage opportunity for investors to capitalize on in the secondary markets.
Such innovative financial engineering had thus created a self-balancing system that looked good on paper but ignored a valuable lesson from the world of finance. Putting too much trust in self-interested market participants to do what you want without binding legal obligations is risky. The epic crash of both UST and LUNA would soon illustrate that lesson in vivid terms and lead to much soul-searching among supporters of algorithmic stablecoins.
Luna comes back down to earth
Although we are still grappling with what exactly pushed UST over the edge — with some attributing the shock to a coordinated token dump — it is clear that the panic spread rapidly. The news of Anchor Protocol replacing its fixed 20% interest rate on UST “savings accounts” with a variable rate sparked the first mass exit. The panic also spread to the UST pool on the Curve Protocol, a DeFi hub for stablecoin liquidity, with investors hurrying to withdraw their commitments and swap their UST for other stablecoins. As market sentiment soured and UST slipped to $0.98, other investors began dumping their UST and LUNA tokens too.
After an enormous amount of UST was burned in exchange for LUNA, it became clear that the UST/LUNA balancing mechanism could not keep up with the market, failing to mint enough LUNA to re-peg UST. Although Do Kwon, the creator of Terra, initially joked his way out of the immediate crisis, the market soon entered a downward spiral, where expectations of even higher LUNA supply (and thus even lower future price) further amplified the selling pressure. Not even a $3bn reserve fund from the Luna Foundation Guard could prove sufficient to stabilize the situation.
On May 11, both tokens crashed violently, with UST falling to $0.29 and LUNA shedding some 97% of its value, never to recover it again. Both are now slowly approaching zero.
Post-mortem analyses would cast the weaknesses of algorithmic stablecoins in a new light. Analysts now had an immediate example to draw upon in demonstrating how the price stabilization mechanisms behind algorithmic stablecoins crumble when demand falls below a certain level. Because such stablecoins are “non-collateralized” (or “under-collateralized”), there are few assets to defend the peg with. This is made worse by traders acting on incomplete information during volatile periods, in an atmosphere of crisis and uncertainty, often triggering further bouts of panic that can bring down the ‘balancer’ token.
Unfortunately for other algorithmic stablecoins, the news of the UST/LUNA crash has reverberated far and wide. Experts in crypto regulation would soon highlight the now precarious position of algorithmic stablecoins, not least because the Terra case has been invoked by Janet Yellen, US Treasury secretary, in calls for stablecoin legislation. With regulators breathing down their necks and the cautionary tale of financial over-engineering held over their heads, other algorithmic stablecoins are now in an uphill battle to prove that their stablecoins are not like Terra’s.
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