Algorithmic Stablecoins and Story of Terra
Bitcoin was introduced with the initial idea of a currency that can be used online as a medium of exchange without any control by the government or any institutions. But the high volatility of cryptocurrencies generally scares away retailers from using them as a medium of exchange. To counter the increased volatility in the prices of cryptocurrencies led to the rise of an idea called stablecoins. Their prices are supposed to remain stable compared to other cryptocurrencies. Terra is one of the cryptocurrencies that made the idea very famous. However, Terra comes under another category of stablecoins called algorithmic stablecoins. Here we will talk about the concept of stablecoins and algorithmic stablecoins.
<b><h2><center>High Volatility in Crypto Prices</b></h2></center>
High volatility in the prices of cryptocurrencies is one of the biggest hurdles to being accepted as a medium of exchange. So if someone gives service or product in exchange for cryptocurrencies and the next day the cryptocurrency is not worth much would create problems for the retailer.
One of the biggest reasons for volatility in the prices of cryptocurrencies is their <b><i>small market cap</b></i>. Cryptocurrency prices fluctuate because it is <b>influenced by supply and demand, investor and user sentiments, government regulations, and media hype</b>. Due to the small market cap, these factors significantly impact the prices.
Stablecoins were introduced as an alternative to the older approach of cryptocurrencies. As the name suggests, the price of stablecoins remains stable compared to traditional cryptocurrencies. <b>Stable coins' values are pegged to a real-world currency reducing the volatility it might face</b>. It gives you a way to use crypto as a much better medium of exchange and allows crypto investors to invest in a much more stable currency than, say, cryptocurrencies like BTC.
So a cryptocurrency called Tether (also called USDT) is pegged to USD such that 1 USDT = 1 USD. But why would people believe in its price? For example, if people wouldn't believe that 1 USDT = 1 USD, <i>they would dump USDTs in the market, and the coin will crash and lose its value</i>. So the companies that own and manage these stablecoins (in the case of the USDT, it is owned by inFinix Inc.) <b>need to own some kind of asset</b> (like cash reserves or some other cryptocurrency, etc.) to back their cryptocurrency so that people have confidence in the worth of the stablecoin (eg. 1 USDT = 1USD).
Taking the example of Tether, 1 USDT is pegged to 1 USD. Hence, the company that owns Tether must maintain a cash reserve in US Dollars same as the amount of Tether in circulation. So if one million Tether coins are in circulation, inFinix Inc. must keep 1M USD of cash reserve as its asset. However, the asset can be anything like Gold or even other cryptocurrencies.
<b><h2><center>The Story of Terra</b></h2></center>
Under stablecoins, there comes a different category called <b>algorithmic stablecoins</b>. Instead of backing the coins with the asset, the <b>coins' price is maintained with an algorithm's help</b>. Terra was one such stablecoin. Terra is managed by a company called <b>Terra Labs</b>, which South Korean entrepreneur Do Kwon founded. There have been attempts on other algorithmic stablecoins even before Terra but Terra "was" the first such coin that tasted some success.
Terra offered <b>low volatility and charged a low transaction fee</b>, making it one of the best options for digital finance. Apart from that, it <b>offered a 20% return</b> to its investors as well. Even though Terra wasn't one of the biggest cryptos in the market, it was adopted by 15 e-commerce companies, mostly in East Asia, making it a good choice for investors to invest. In January 2022, Terra was the 4th largest cryptocurrency by market cap.
<b><h2><center>How Did Terra Work?</b></h2></center>
The algorithmic stablecoins generally have two different cryptocurrencies in their ecosystems. In the case of Terra, the two coins were <b>Terra USD (UST) and Luna (LUNA)</b>. UST was to remain stable with a consistent price of 1 USD; on the other hand, Luna was supposed to absorb the volatility based on the demand and supply of UST.
So one can buy UST on market exchanges or exchange UST for LUNA within the system. <b>But at all costs, the system tries to keep everything in equilibrium</b>. So as 1 UST was pegged to $1 worth of Luna, that meant that while the amount of Luna handed over in a swap for UST would vary, a holder of $1 in UST would always get $1 in value back. And all the system's stability was maintained by an algorithm by varying the amount of Luna in circulation. There were also <b>"financial incentives" for people to exchange and trade LUNA and UST to help keep the system in equilibrium</b>. How were these financial incentives gained?
When the market value of one UST is greater than 1 USD, there is an incentive to trade 1 USD worth of Luna for one UST. You could wait and exchange UST when its price is back to 1 USD. The exchange puts more UST into circulation, driving down the cost of UST to 1 USD. Similarly, if one UST is less than 1 USD, you could trade 1 USD forth of UST for Luna, which is worth more. This process is a win-win for both investors and the Terra ecosystem. Terra system achieves stability, and investors would earn some money.
<b><h2><center>Problems With Algorithmic Stablecoins</b></h2></center>
But there can be a problem with the algorithmic system. As the number of Luna in the market and the number of UST in the market are directly dependent on each other, this can lead to a problem if the <b>price of UST dips a bit too much</b>. The price dip may occur if someone holding a lot of coins decide to dump/withdraw a big chunk of their money altogether.
The sudden increase in the number of stablecoins (in this case, UST) will disbalance the system as the supply would increase, but there isn't enough demand for the coins. The price of stablecoin will drop as the supply is more than the demand. So UST's cost, which was supposed to remain at 1 USD, would drop a lot (say 0.9 USD, which is a lot in this case). This will lead other people to exchange or withdraw their share in UST.
<b>The algorithm will keep generating more and more Luna coins to keep the price stable at 1 USD</b>. The algorithm is causing too many Luna coins, but the demand is not very high. The algorithm is doing so to keep the price of UST stable at 1 USD. This will create a feedback loop, and the algorithm will keep generating more Luna coins driving the cost of the coins down, leading to a <b>death spiral</b>. This is what happened with Terra.
<b><h2><center>How Did This Happen?</b></h2></center>
According to workers at Terra Labs, this was a coordinated attack. Someone bought a large amount of UST with bitcoin and dumped it all together in the market to bring the system down. They believe that the perpetrator was a large hedge fund, but there is no evidence. The crash was pretty bad for Terra investors. If you invested 1M USD in Terra a week before the crash, it would be worth 3 USD after the crash.
- Ojas Srivastava, 01:46 AM, 03 Aug, 2022