“We’ve had a real life demonstration of the risks,” said U.S. Treasury Secretary Janet Yellen on Thursday, referring to last week’s meltdown of the Terra and Luna cryptocurrencies. Speaking during a House committee hearing on Thursday, Yellen also said that volatility in the crypto market presents “the same kind of risks that we have known for centuries in connection with bank runs.” A run — or sale by many owners — causes sudden and often severe price depression.
Terra is called a stablecoin by the company behind it. Stable coins are a cryptocurrency pegged to a specific value, usually the dollar, another currency, or gold. Its parity with the dollar is what, in theory, makes it stable. The idea is that whenever someone wants to cash in, they can get the equivalent amount of dollars for however many stablecoins they wish to sell. Stablecoin issuers are meant to hold a sufficient level of money corresponding to the number of tokens in circulation.
Today, the entire market for stablecoins is worth more than $160 billion, according to data from CoinGecko. Tether is the world’s biggest, with about $80 billion market value.
UST (the symbol Terra uses to trade on cryptocurrency exchanges) is a unique case in the stablecoin world. Unlike tether, it didn’t have any actual cash to back its purported peg to the dollar — though it was at one point partially backed by bitcoin.
Instead, UST relied on a system of algorithms. It went something like this:
· The price of UST can fall below a dollar when there are too many tokens in circulation but not enough demand
· Smart contracts — lines of code written into the blockchain — would kick in to take the excess UST out of supply and create new units of a token called Luna, which has a floating price
· Traders were encouraged to engage in arbitrage and profit from deviations in the price of the two tokens
· The idea was that you could always buy $1 worth of Luna for one UST. So if UST was worth 98 cents, you could essentially buy one, swap it with Luna, and pocket 2 cents in profit.
To create UST, you need to burn Luna. Fifteen days ago, you could trade one Luna token for 85 UST (since Luna was worth $85), but the Luna would be destroyed (“burned”) in the process. As more people buy into UST, more Luna would be burned, which the company behind Terra claimed would make the remaining Luna supply more valuable. This notionally deflationary protocol was meant to ensure Luna’s long-term growth.
The whole system was purported to stabilize UST at $1. But it crumbled under the pressure of billions of dollars in liquidations — particularly on Anchor, the Terra lending platform that promised users interest rates as high as 20% on their savings.
To entice traders to burn Luna to create UST, creators offered an eye-popping 19.5% yield on staking -- which is crypto terminology for earning 19.5% interest on a loan -- through what they called the Anchor Protocol. Instead of parking your savings at a bank for a 0.06% interest rate, the pitch is to turn put your money into UST, where it can earn nearly 20% in interest. Before the run on Terra, over 70% of UST’s circulating supply, around $14 billion, was deposited in this scheme.
The UST coin has since fallen to just 9 cents, up from a low of 4.4 cents. Then there’s Luna, the centerpiece of Terra’s ecosystem. Its value has collapsed in one of the most stunning crypto crashes ever recorded.
Luna’s price fell from $116 in April to just a penny on Thursday. It fell further over the weekend, trading for a fraction of a cent. At the time of writing, Luna is down to a hundredth of a penny. Such an implosion has never been seen in the cryptocurrency markets.
Luna had a market cap of over $40 billion just last month. Its collapse is part of the more than $270 billion of value erased in last week’s meltdown.
The U.K. government is also taking notice. A spokesperson for the government told CNBC Friday that it stands ready to take further action on stablecoins after Terra’s collapse. “The government has been clear that certain stablecoins are not suitable for payment purposes as they share characteristics with unbacked cryptoassets,” the spokesperson said.
Britain is planning to bring stablecoins within the scope of electronic payments regulation, which could see issuers such as Tether and Circle become subject to supervision by the country’s markets watchdog. Separate proposals in the European Union would also bring stablecoins under strict regulatory oversight.
“A decentralized stablecoin is the Holy Grail of DeFi,” said Cyrus Younessi, former head of risk management at MakerDAO, the group behind the DAI stablecoin. The selling point of bitcoin and ether is that they’re difficult for bureaucrats, politicians, and central bankers to control, but their downside is price volatility. “If you could take those assets, extract stability out of them and productize it, then that’s huge,” Younessi said.
While the case for algorithmic stablecoins is a tough one, the search for the Holy Grail continues.
About Dana: Dr. Dana Love is currently the CTO of Lifetoken Software. Love is a 32-year technology veteran who has been active in bitcoin and blockchain since 2011. From 2018-22 Dr. Love founded and led blockchain payment platform Radpay, where he was recognized as a fintech innovator by both 500 Startups and the Arizona Commerce Authority. From 2012-18 Dana spearheaded four different blockchain ICOs and led different enterprise leadership roles. From 2007-12, as CEO of military contractor Bright Dawn, Dana led development of complex real-time data systems, big data and data fusion projects, and a variety of digital and kinetic work for the IC, Defense, and civilian agencies. From 1995-2007, Love founded or served in leadership for a variety of firms, including Cisco Investments-backed Metacloud and Warburg Pincus-backed Radnet, and led divisions of public companies including GTE (now Verizon), Prosodie (now Cap Gemini), and ADC. Dana’s career began in civilian service to the U.S. government. Dana Love holds a doctorate in public policy economics from the University of Glasgow, is a Harvard Business School Baker Scholar, and graduated from the University of Richmond.