What can other algorithms of stablecoins learn from the collapse of Terra?

What can other algorithms of stablecoins learn from the collapse of Terra? – Mail Bonus

The spectacular collapse of the Terra ecosystem in mid-May made the cryptocurrency industry scarce. Although there were brave critics who understood how thin the razor was for TerraUSD (UST) – now the TerraUSD Classic (USTC) – I think it’s safe to say that most people did not expect Terra to fail so quickly, so wonderfully and so completely irreversible.

I’m writing this as the Terra community is voting for a plan to reboot some kind of Terra 2.0 – a plan to save the layer-1 ecosystem without UST stablecoin. The old Terra, now known as the Terra Classic, is completely dead. An unsuccessful attempt to stop ICT holders printed trillions of LUNA tokens, destroying their value and ultimately endangering the security of the network itself.

A total extinction of $ 50 billion in value seems to have made people decide once and for all that the stablecoins algorithm can not work. But I think it’s important to have a more nuanced understanding of why the original LUNA failed and how others can learn from its lessons.

Connected: Terra 2.0: A cryptocurrency-based cryptocurrency project worth $ 40 billion

Stablecoins: A new name for an ancient concept

The term stablecoin mostly evokes US dollar-denominated currencies that aim to maintain $ 1 value. But it is important to remember that this is mainly a matter of convenience. You can use the same methods that support existing USD stablecoins to create currencies linked to the euro, gold, even Bitcoin (BTC), Nasdaq futures, or any particular stock, such as Tesla (TSLA).

It’s also interesting to note that stablecoins are not really a new cryptocurrency. Modern Stablecoin designs are closely related to either how money works according to a gold standard – for example, Maker’s Dai is a hard collateral requirement just as previous banknotes were gold box requirements – or they are a remake of fixed currencies such as the Hong Kong dollar.

HKD is a very interesting example in all of this because it’s pretty much your “algorithmic stablecoin” you want. It is pegged to the US dollar, even if it is not in a 1: 1 ratio, and HK’s central bank uses its large reserves to keep HKD’s prices in a well-defined ratio by trading it on the market. Recent estimates put Hong Kong’s $ 463 billion in foreign exchange reserves, six times HKD in direct traffic and almost half of its M3, the broadest definition of “money” that does not include immediate liquid assets (such as locked-in bank deposits).

The only reason HKD is not technically an algorithmic stablecoin is that it is a central bank that conducts market operations. In decentralized financing (DeFi), the central bank is replaced by algorithms.

Connected: UST sequel: Is there a future for algorithmic stablecoins?

Terra is also no HKD

Confusing Terra with the algorithm of the stablecoin space, in general, does not understand why Terra collapsed as much as it did. It’s important to realize how sensitive Terra’s design was. In a nutshell, UST was the “guarantee” of LUNA, the Terra blockchain gas brand. Because it was a fairly reliable DeFi and unchangeable symbol ecosystem developed on Terra, the LUNA symbol had some intrinsic value that helped to increase the initial supply of ICT.

How the hardware worked was basically similar to HKD. If UST traded above $ 1, users could acquire a small LUNA and burn it for its dollar value in UST. Most importantly, the system assumed that ICT was worth $ 1, so the LUNA burner can only sell ICT on the market for, say, $ 1.01 and make a profit. They can then recycle LUNA’s profits, burn them again and continue the cycle. Eventually, the barrier would be restored.

If UST was traded below $ 1, the reverse gear helped to stop it. Arbitrators would buy cheap UST, redeem it for LUNA at a price of 1 UST equivalent to $ 1, and sell these tokens on the market at a profit.

This system is great for holding the plug under normal conditions. One issue with Dai, for example, is that it is not possible to judge directly for the underlying insurance. Arbitrators need to “hope” that the connection will stabilize for a profit, which is the main reason why Dai is so dependent on USD Coin (USDC) now.

But we also need to mention the great responsiveness in Terra’s design. Demand for ICT, which means that it exceeds the connection, leads to demand for LUNA and thus an increase in prices. The key to this arrangement was Anchor, Terra’s lending protocol that secured a 20% APY to ICT parties.

Where did the 20% APY come from? From extra UST coins through LUNA’s Terraform Labs reserve fund. A higher price for LUNA meant that they could hit more UST for anchor returns and thus increase the demand for UST and raise LUNA’s price – that way they could hit even more UST …

UST and LUNA were in a cycle of reactionary demands that, let’s face it, had all the elements of Ponzi. The worst thing was that there was no ceiling on how much ICT could be beaten as, for example, a percentage of LUNA’s market value. It was driven solely by responsiveness, which meant that just before the crash, $ 30 billion of LUNA’s market capitalization supported US $ 20 billion in market value.

As Kevin Zhou, founder of Galois Capital and a famous critic of LUNA and UST before it collapsed, explained in an interview, every dollar invested in a volatile asset increases its market value by eight times or more. In practice, this meant that ICT was heavily under-mortgaged.

Stings in a sphere

It is difficult to pinpoint the reason why the crash started when it happened, as there were certainly many factors going on. For the first time, the Anchor reserves were apparently depleted, with only a few months left of yields, so there was talk of reducing yields. The market also did not go too well as most large funds began to expect some kind of big collapse and / or long-term bear market.

Some conspiracy theorists blame TradFi giants like Citadel, or even the US government, for “shortening” ICT by billions and launching a bank robbery. However, this is a cryptography: If it is not the US government, then there will be some rich whale who wants to be known as the return of Soros (who was famous for shortening the British pound when it had a similar connection, known as Black Wednesday Although the pound is not as dramatic as Terra, the pound lost 20% in just two months).

In other words, if your system could not handle coordinated and well-funded attacks, then it was probably not a good system to begin with.

Terraform Labs sought to prepare for the inevitable, raising a total of 80,000 BTC to prevent the connection. It was worth about $ 2.4 billion at the time, not nearly enough to solve all the ICT owners who wanted to quit.

The first depegging event between May 9 and 10 took UST at about $ 0.64 before recovering. It was bad, but not fatal yet.

That is an underestimated reason why ICT never recovered. The LUNA redemption method I explained earlier was a maximum of about $ 300 million a day, which was ironically done to prevent a bank run for ICT from ruining LUNA’s value. The problem was that LUNA collapsed anyway and quickly went from $ 64 to just about $ 30, which was already $ 15 billion in market value. The Depeg event barely thwarted the UST supply, with more than 17 billion remaining out of the original 18.5 billion.

As Do Kwon and TFL remained silent for the next few hours, the price of LUNA continued to fall without any significant redemption measures, reaching a single-digit low. It was only here that the management decided to raise the redemption ceiling to 1.2 billion dollars when the market value of LUNA had already been reduced to 2 billion dollars. The rest, as they say, is history. This sudden decision sealed the fate of the Terra ecosystem, which led to hyperinflation and later the suspension of the Terra blockchain.

Connected: Terra’s melting underscores the benefits of CEX risk management systems

It’s all about insurance

Successful examples from TradFi such as HKD should be an indication of what happened here. Terra seemed to be over-mortgaged, but it really wasn’t. The actual mortgage before the crash amounted to maybe 3.6 billion dollars (the Bitcoin reserve plus Curve liquidity and a few days worth of LUNA redemptions).

But even 100% is not enough when your collateral is as volatile as a cryptocurrency. A good insurance ratio could be between 400% and 800% – enough to account for the valuation that Zhou mentioned. And smart deals should strictly enforce this and prohibit the currency being struck if the mortgage is not ideal.

The backup should also be a maximum algorithm. So, in the case of Terra, Bitcoin should have been placed in an automated stability unit instead of an opaque market maker (although here just was not enough time to build it).

With secure insurance variables, a little variety and actual use case for the property, algorithmic stablecoins can survive.

It’s time for a new design for algorithmic stablecoins. Much of what I recommended here can be found in the Djed White Paper that was published a year ago for the over-pledged stablecoin algorithm. Nothing has really changed since then – the Terra collapse was unfortunate but predictable, given how underpinned it was.

This article does not include investment advice or advice. Every investment and trading business involves risk and readers should do their own research when making a decision.

The views, thoughts and opinions expressed herein are the sole responsibility of the authors and do not necessarily reflect or represent the views and opinions of the Cointelegraph.

Shahaf Bar-Geffen has been CEO of Coti for more than four years. He was also part of the Coti founding team. He is known as the founder of WEB3, an online marketing group, as well as Positive Mobile, both of which were acquired. Shahaf studied computer science, biotechnology and economics at Tel Aviv University.