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Terra co-founder Do Kwon became an industry hero when he promised to buy $10 billion of Bitcoin back in March. Now, he’s become crypto public enemy number one.
Two months after the announcement, his blockchain’s dollar-based stablecoin, TerraUSD (UST), has depegged to just $0.15. Meanwhile, Terra’s governance token LUNA has collapsed to absolute zero, destroying investors who HODL’d through its collapse.
Kwon and the Luna Foundation Guard fought to defend the peg by selling their Bitcoin reserves to pump UST’s price. Sadly, their attempts were unsuccessful, and the co-founder finally conceded on Friday that the UST stablecoin project has failed.
What went wrong? Some believe the collapse was related to Terra’s massive Bitcoin investment, given its temporal proximity. However, these reserves were still being built. Until now, UST was only ever backed by LUNA, with plans to shift to Bitcoin convertibility in the future.
Rather, the problem was the opposite. UST should have always been backed by Bitcoin, and supporting it with LUNA was a fool’s errand from outset.
Here’s what exactly caused UST to fall apart, and what a functional algorithmic stablecoin, backed by Bitcoin, would look like.
Sparking the Crash
The failure of both UST and LUNA was an unraveling of sorts, carried mostly by the faulty tokenomics behind each coin. However, that unraveling began with a spark: hundreds of billions of dollars in UST getting dumped on the market.
It doesn’t appear to have been an accident either. According to Ronald AngSiy – Senior Vice President at defi venture capital firm Intellabridge – the dump was clearly a malicious attack.
“There were two entities that, in a 24-hour period, sold over four hundred million dollars of UST,” he explained in an interview with Kitco news. The sold UST was originally withdrawn from Anchor protocol – the Terra ecosystem’s main yield protocol. It was then dumped on Curve, an Ethereum DEX that lacked substantial UST liquidity at the time.
The relatively small amount of liquidity being struck by such large Terra supply created major spread, and brought UST’s price down to just $0.92.
Speculation remains about who could have been behind the short attack, but the fact remains that it was successful. It didn’t only decrease the price, but caused a crisis of confidence in the nascent stablecoin that shook the foundation of its stability.
The Self-Fulfilling Meltdown
While the short attack was well-timed and orchestrated, Terra could have survived it if its peg system wasn’t so fragile.
To be clear, stablecoins do not have a magical recipe for maintaining dollar equivalency at all times. Their prices are subject to supply and demand forces like any other cryptocurrency. However, with the right incentives, supply and demand can be managed such that a currency’s value moves in lockstep with another chosen currency.
Traditional stablecoins like Tether and USDC make this possible by backing their coins with actual dollars. That means a USDT or USDC coin is convertible for exactly $1.00 at any time. Therefore, if the market ever prices these coins above or below a dollar, users may arbitrage them with the reserve for a profit. This will ultimately bring their market value back to one dollar within short order.
Until recently, the same could be said of UST – except for two key differences. Firstly, users couldn’t convert UST for a dollar, but a dollar’s worth of LUNA, at any given time. Secondly, Terra never actually held a fixed reserve of LUNA to supply stablecoin redeemers. Instead, the protocol would simply mint new LUNA when UST was burned, and burn LUNA whenever UST was minted.
The problem with this system struck when UST was brought grossly off peg. Stablecoin holders were incentivized to start burning their UST for a dollar worth of LUNA each. Then, they would come back to market and sell their LUNA for dollars, or buy more UST than they started with.
This indeed results in taking some UST off the market, helping to restore its price. However, it also means flooding the market with LUNA, therefore diluting the governance token’s price until the UST peg is restored.
Combined with the market-wide crash at the time, LUNA’s price dropped by over 50% in a day on Monday. Its dilution continued until Friday, when LUNA’s supply had grown to a whopping 6.5 trillion tokens from only about 90 million on Sunday.
The Problem With Unstable Reserves
Though not actually on “reserve”, LUNA was the asset that technically “backed” UST at all times. As long as $1 of LUNA could be minted for every UST redemption, why didn’t the stablecoin’s price eventually recover?
In truth, stablecoins are not merely backed by reserves, but by investor confidence in said reserves. If they see the underlying token collapsing in real-time, they realize that their stablecoin is backed by nothing but a valueless, non scarce asset. This started became clear as early as Monday, when LUNA’s market cap fell below that of the cryptocurrency is hypothetically backed.
When the underlying asset – LUNA – loses investor confidence, potential buyers will flee the cryptocurrency. Exchanges will also begin halting trades and delisting the asset, while validators may freeze the blockchain supporting it entirely.
Each of these developments decreases the reliability of cashing out from one’s LUNA. Thus, UST holders lose confidence in the stablecoin’s conversion system, as the LUNA they receive in exchange becomes less liquid over time.
The result is twofold. First, UST holders run for the liquidity exits through dollars and other cryptocurrencies on exchanges. Secondly, they rush to convert their UST for LUNA before their peers in a classic bank-run-style panic event.
Even as UST is burned in the process, it fails to recover its value as it becomes just as undesirable as its underlying token. As Kwon explained in Terra’s post-mortem: “UST has lost too much trust with its users” to serve as money anymore.
Why Bitcoin is Different
By adopting Bitcoin reserves sooner, Terra could have better protected the confidence in, and price of UST.
There are, of course, countless differences between Bitcoin and LUNA. However, there are two that namely make or break each coin’s viability for backing an algorithmic stablecoin.
Firstly, Bitcoin’s market is vastly more liquid than LUNA’s. Selling the former, even in large quantities, is far less likely to create a spreads or devalue the currency as a whole. Therefore, Bitcoin could tolerate more erratic price swings from UST and still reliably recover the peg.
Secondly, Bitcoin is immune to the inflationary death spiral that caused LUNA to collapse to zero. Its supply is programmatically fixed at 21 million coins, making it reliably scarce, trustworthy, and valuable.
This isn’t a new thought. In fact, one of the first people to note the advantages of a Bitcoin based stablecoin system was Do Kwon himself. In an interview with Annthony Pompliano in March, the co-founder stated:
”You can say whatever you want about Bitcoin, but at the end of the day, it is the soundest and most credibly neutral asset in the digital asset space. There’s no equal.”
Furthermore, Kwon even recognized that transitioning to this system would protect the network from the exact catastrophe that befell it.
“Algorithmic stablecoins are more brittle when it comes to changes in user demand,” he explained. “If you have too many people that are divesting out of that stablecoin all at once, too much of the paired asset gets printed, and therefore there’s a debt spiral in the overall economy. “
As mentioned, Bitcoin is a truly scarce asset outside of any sole party’s control. Therefore, Terra could not create a Bitcoin based system right away until it had actually purchased enough Bitcoin from the market to use as reserve collateral.
Until this month, UST was in a transition phase wherein UST was still backed by LUNA. Meanwhile, the Luna Foundation Guard was steadily adding Bitcoin to its reserves, hundreds of millions of dollars at a time. This created both excitement and price action within the Bitcoin community at the time but did not affect UST’s stability.
Kwon claims that the blockchain was only weeks away from launching a testnet for UST/ BTC convertibility. Sadly, the Terra economy went south and collapsed before that could happen.
That said, even his ideal solution wouldn’t have been perfect. While $10 billion in Bitcoin may sound immense, it would not have been enough to cover UST’s existing $20 billion market cap. Furthermore as Bitcoin is still prone to volatility, the reserve would need to be overcollateralized to maintain its peg at all times.
Still, Bitcoin has the properties to become a value stable “digital gold” in the future. If this happens, it could arguably become the premiere, maximally reliable, and decentralized reserve asset for stablecoins.
So what now? As of today, Do Kwon has declared UST – and the Terra chain as we know it – dead. He intends to fork the chain, create a new LUNA token, and distribute it among all impacted UST/ original LUNA holders. Any plans for a new algorithmic stablecoin have been put on hold. The vote on whether to execute this will commence within 48 hours.
Meanwhile, the LFG’s massive Bitcoin reserves – which swelled to 80,000 – have all been dumped. The guard confirmed that only 313 BTC remain, having been lost in a “last-ditch effort to defend the peg”.
Regulators have taken notice. It appears that rules of the road are fast coming for the crypto space – and rightfully so. Stablecoins cannot be backed by unstable assets and recursive logic – only by scarce, trusted, and truly “stable” assets.