TerraUSD Panic? The “No. 3 Stablecoin” Doesn’t Have a Single Dollar Behind It

Terra’s LUNA Has Dropped 99.7% in Under a Week creating a panic on the whole market. Several other major assets have plummeted last with Ethereum down 20% and the likes of Solana and Cardano both shedding over 30% of their value. As investors rush to exit the market, USDT has lost its peg against the dollar, briefly hitting a low of $0.95. Nonetheless, while the market bleeds, no project is facing as much of an uphill battle as Terra. 

Even if you’ve been following the debate over stablecoins, the dollar-pegged digital assets that have become the bogeyman of crypto. There are a number of reasons for that, but the most notable is that if you go back six months, no one else outside of the core cryptocurrency industry had heard of it either..

Today the previous $17.9 billion, made it the third-largest stablecoin, behind Tether’s USDT ($83 billion) and Circle’s USD Coin, or USDC ($49.9 billion).

That’s a growth curve that would put it squarely in the crosshairs of the regulators, financial watchdog organizations and politicians who believe stablecoins will cause financial mayhem if they are allowed to become a serious payments rail without any other cause.

But TerraUSD has another target on its back: It is an algorithmic stablecoin, with a dollar peg backed not by a one-to-one cache of fiat currency and highly liquid investments like short-term Treasury Notes. Instead, it is backed by capitalism, or more specifically, by arbitrage.

Let’s go in the details to understand how this has happened.

Arbitraged Stability

Algorithmic stablecoins work because they are linked to a governance token, a separate, free-floating cryptocurrency that gives the holder a vote in the decentralized autonomous organization, or DAO, that governs both itself and the stablecoin.

TerraUSD works in tandem with a cryptocurrency called, confusingly, Terra, so we’ll refer to it hereafter by its exchange symbol, LUNA.

To buy the TerraUSD stablecoin, you have to mint new tokens, and to do that, you have to buy LUNA. The minting process burns — destroys — those LUNA tokens. That, Adam Smith tells us, should reduce the supply and thus increase the price. You then have dollar-pegged stablecoins that can be used as a currency for any type of transaction.

It works the same in the other direction: to mint LUNA, you have to burn TerraUSD. That increases the supply of LUNA, which should in turn decrease the price.

The way the stable part of the stablecoin works is that arbitrageurs buy and sell large amounts of tokens when small price discrepancies in the dollar peg appear. So, they’ll sell LUNA when the stablecoin falls slightly below $1 and buy it if the price rises above $1, using volume to make profits on tiny margins.

Shoot the Moon

What differentiates TerraUSD from the first major algorithmic stablecoin, MakerDAO’s DAI, is the market cap of their respective governance tokens.

DAI has a market cap of about $9 billion, but it’s Maker (MKR) token has one of $1.7 billion, making it the No. 60 cryptocurrency.

LUNA, however, has a marketcap of $32.9 billion, making it the eighth-largest cryptocurrency. It just passed another fiat-backed stablecoin, Binance’s BUSD, with a $17.3 billion market cap.

Top 10 cryptos tend to be volatile, and they also tend to attract a lot of buyers without the understanding of the cryptocurrency market that smaller tokens attract — say those down at No. 60.

In the Crosshairs

With stablecoins, you can add in a healthy dose of partisan rancor on Capital Hill.

And, they tend to attract the notice of politicians and regulators.

There are two major concerns about stablecoins. Long-term, they could bypass national currencies, threatening countries’ control over their monetary systems and ability to fend off economic downturns.

Just as serious but more immediate, there is a fear that if they are allowed to thrive they will risk financial mayhem and stability-endangering runs if consumers lose faith that the dollar-pegged cryptocurrencies are really backed one-to-one by a cache of fiat currency.

It’s serious enough that their spectacular growth — their combined market capitalization was $7.8 billion in April 2020, and is now north of $180 billion — has become one of the driving forces behind the worldwide movement towards central bank digital currencies.

They’ve gotten plenty of attention from the administration, with the President’s Working Group on Financial Market’s November stablecoin report recommending they all be issued by FDIC-insured banks.

Which doesn’t leave much room for TerraUSD’s algorithmic stablecoin.

Earn Yield on your TerraUSD’s

Anchor protocol is a DeFi application that promises to pay 18% APY for UST stablecoin deposits.

Stablecoin deposits may earn interest through the Anchor System, a lending and borrowing protocol. Lenders can make significant returns on their UST assets while also enjoying low volatility by storing them in a bank. Borrowers retain full ownership over the LUNA collateral they provide as security.

The UST protocol allows borrowers to borrow in stablecoins without risking their investments, and lenders to get a competitive interest rate on stable assets. Individuals can use the UST system to borrow up to 60% of the value of their deposited collateral at a little higher interest rate than they would pay to lenders. There are bLUNA tokens, which are LUNA tokens that may be exchanged for loans (bonded LUNA) The Anchor Yield Reserve is responsible for funding the protocol’s expenses when interest rates change.

Terra Aimed to Avoid Collapse

The Layer 1 blockchain’s development company, Terraform Labs, shared a new update recently detailing a host of emergency measures it’s proposing to save the network from total collapse. 

They include a plan to accelerate the UST burning rate, which Terraform Labs CEO Do Kwon also endorsed in a statement Wednesday. The proposal would see UST’s daily minting capacity increase from $293 million to $1.2 billion, meaning holders would be able to cash out their UST for LUNA. It’s hoped that this could bring UST closer to peg, but it also means LUNA’s supply will increase at a faster rate. The proposal has received over 450 million LUNA votes at press time, with just over 50% voting in favor of the move. Around 49% have abstained from the proposal, and the remaining minority has voted against it. It ends in six days. 

Terraform Labs has also proposed several additional “emergency actions” to save the network. They include burning all remaining UST held in Terra’s community pool, burning an additional 371 million UST currently held on Ethereum, and staking 240 million LUNA tokens “to defend the network from governance attacks.” 

Terra has faced a meltdown this week as its algorithmic stablecoin, UST, has lost its peg. While UST is intended to follow the price of the dollar, it briefly hit lows of $0.30 last Wednesday and is still trading below peg at $0.50. Terra’s volatile token, LUNA, hasn’t fared much better: it’s currently trading under $0.05, down 99.9% last week. Five weeks ago, it was worth $119 at its peak. The crash has been described as one of the fastest and most brutal in crypto history, and it’s had severe consequences for the rest of the market.