Lessons from Terra Crash and the Future of Stablecoins

Volatility has always been a close relative of cryptocurrencies since Bitcoin - the first cryptocurrency - was created until today, and this inconsistency will continue in the future. Despite volatility being a norm in the crypto industry, investors, traders, and everyone was shocked in May 2022 following the sudden crash of stablecoin TerraUSD and its sister coin, Luna.

Stablecoins are usually pegged to fiat currencies; as their name implies, they are created to maintain a constant value over time. In its case, TerraUSD was pegged to the US Dollar until May 2022, when it lost its peg, dragging other digital assets on a downward slope and obliterating several billions of dollars from the cryptocurrency market.

What are Stablecoins, and How does Pegging Work?

Stablecoins are created to allow investors to survive the volatility of cryptocurrencies by pegging them (the stablecoins) to a fiat currency, while enabling holding of money on decentralized protocols. Tether (USDT) and Circle’s USDC, the two biggest stablecoins, are pegged to the US dollar. Being pegged to the dollar implies that the value of USDT and USDC will always be equal to $1. Both these stablecoins claim that their tokens are backed 100 percent by their reserves, the majority of which are made up of cash and “cash equivalents”

Rather than converting their crypto assets into fiat, investors can convert to stablecoins when the value of a cryptocurrency is dropping. So, if the price of Bitcoin drops from $66,000 to $60,000, an investor can convert one Bitcoin into 60,000 USDC. If the price of Bitcoin further reduces to $30,000 after a month, the investor can trade the 60,000 USDC for 2 Bitcoin.

Stablecoins provide a middle ground for fiat currencies and cryptocurrencies. While these protect investors from market volatility, they also solve the problems of centralization, high transaction costs and requirements of collateral & correspondent banking networks. Stablecoins also provide a platform for people to lend and/or borrow assets on the blockchain.

The Terra-Luna ecosystem and the UST Peg

Terra is a blockchain protocol that produces Luna as its native token. Through a truly innovative algorithmic set up, the Terra protocol pegged UST to the US dollar, while all volatility was sucked in by its sister token - Luna

The way in which the protocol worked was that to create UST you had to burn Luna. So, for example in April 2022, when Luna was trading at $119, if there was a demand for UST, the protocol would burn 1 Luna to mint 119 UST. Similarly, if the demand for UST went down, the protocol would mint Luna and burn UST. The key to retaining the US dollar peg was that 1 UST was always tradeable with 1 Luna.

Unlike, USDC and USDT, the creators of Terra-Luna ecosystem, Terraform Labs initially did not have reserves to back the peg of UST. However, as the supply of UST grew rapidly, Terraform Labs created the Luna Foundation Guard, a consortium whose job was to protect the peg through reserves. The LFG procured about $2.3 billion in bitcoin reserves, with plans to expand that to $10 billion worth of bitcoin and other crypto assets. If UST dipped below $1, bitcoin reserves would be sold and UST bought with the proceeds.

The Anchor Program

The price of Luna rose to an all-time high of about $119 in April 2022, and this fame was a result of a lending protocol called Anchor. Anchor allowed investors to stake their UST for a 20% annual percentage yield (APY). The staked funds would be used as loans, and the interests derived from the loan will be used to pay the investors.

The reason why the Terra-Luna protocol launched Anchor seemingly, was to entice investors to demand UST, that offered a much higher rate of return, than parking it in a bank at a few basis points interest rate. Given the deflationary impact of UST demand on Luna, this would drive up the price of this token, thereby generating value for Luna token holders

It was discovered that over 70% of Tera holders had staked their assets in the Anchor pool. Statistics from Terra revealed that for every borrower, there were about four lenders in the Anchor program, which caused the supply of Terra to grow larger than the demand. Since there were no borrowers to generate the APY for investors, Terra’s founder bought UST tokens to meet the interest rate.

The demand and supply ratio eventually broke, and people began to convert their Terra tokens to Luna. Popular lending platform Celsius made a big move by pulling out over $500 million staked in Anchor, and many investors replicated this action. Over $ 2 billion worth of Terra was unstaked from Anchor, which caused Terra's price to go further down to $0.91.

A massive dump of Terra and Luna tokens forced the price to go massively downwards. Luna token went from $85 in early May to less than a cent by mid-May. LFG tried to fight the de-pegging using the Bitcoin reserves at their disposal, but to no avail.

What is the Future of Stablecoins?

The de-pegging of UST and Luna's crash does not denote that algorithmic stablecoins are fundamentally unsafe or risky. The reality is that the concept of a fiat pegged stablecoin, algorithmically tied by to a volatility-sucking sister token, was truly innovative and inspirational. The issue was that in order to drive up price for the sister token holders, an unviable yield (under the garb of guaranteed returns) was offered, and that took the Terra-Luna ecosystem down.

During the Terra crash, Bitcoin and other cryptocurrencies dropped in value but another stablecoin USDC maintained its dollar peg. The simplistic argument is that this stability was a result of the reserves that USDC is backed by. Unfortunately, such an argument misses the hard reality that even USDC promises yield – though much lower at 4.5% - to holders of the token. This yield could also be under stress (there is no fundamental reason to argue that 20% was unviable and 4.5% is viable), unless there are clear use cases that generate value, which can be returned as yield to investors who stake their USDC tokens and to keep the ecosystem running.

There is a possibility that regulators may ban algorithmic stablecoins to prevent a repeat of the Terra incident. This would, in our view, be unfortunate and a knee-jerk reaction to the collapse of UST. The regulators should focus their attentions more on promises of yield, their sustainability and promises (implicit & explicit) being made to token holders, because that is where the bigger issues are.