“All bleeding stops eventually,” wrote Samuel Shem in his satirical 1978 novel The House of God. The bleeding continued this week in the cryptocurrency market as the fallout of algorithmic stablecoin Terra spread over the past few days to a similar stablecoin, Deus Finance’s DEI stablecoin. DEI operates within Deus, a decentralized finance project based on the Fantom blockchain.

Stablecoins are cryptocurrencies pegged to a specific value, often the U.S. dollar. This 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.

Algorithmic stablecoins generally don’t hold money to provide stability. Instead, they rely on a series of algorithms to maintain stability. Over the past ten days, that stability was sorely tested. It objectively failed.

The incentive structure to maintain stability in Deus and TerraLabs is effectively an arbitrage transaction. Deus Finance uses two tokens called DEUS and DEI. The former is the project’s native governance token, and the latter is its dollar-pegged stablecoin. The dollar-peg of DEI is stabilized much like Terra’s UST, using a similar mint-and-burn mechanism between DEUS and DEI.

DEI is minted using either just DEUS or by using a combination of DEUS and select other cryptocurrencies. During DEI minting, the DEUS collateral is burned (a process of removing the tokens from the circulation) unless a different form of collateral is used (such as USDC, FTM, or WBTC.) When redeeming DEI for the underlying collateral, DEUS tokens are also minted alongside the underlying collateral.

If you were to mint DEI using only USDC as collateral, you would receive 80% in USDC and 20% in DEUS when you redeem your DEI. Redemption is the process of swapping a stablecoin for its collateral.

If the price of DEI is above $1, users can mint 1 DEI using $1 worth of collateral and sell them in the market to pocket the difference as profit. When DEI falls below a dollar, users can buy one DEI for less than a dollar on the open market and redeem them for $1 worth of collateral in USDC and DEUS.

And as happened over the past few days, if the open market value of DEI falls below $0.80, a significant arbitrage opportunity becomes apparent: you can buy DEI on the open market and redeem it for $0.80 in USDC and $0.20 in DEUS. As of writing, DEI was trading for $0.5984.

On May 17, Deus suspended all redemptions. While this stops trades from being conducted for some time, it does not address the broken underlying incentive structure. Both algorithmic cryptocurrency projects wrote code expecting different behavior from traders. Both were predicated on an irrational outcome. The arbitrage traders behaved rationally while trading, which supported the projects during boom times and eviscerated them during a downturn.

Terra went a step beyond suspending redemptions, stopping all block validations. Terra’s founder Do Kwon then proposed a plan to launch a modified version of its cryptocurrency Luna.

Terra’s “Revival Plan v2” will today be voted on by holders of the embattled cryptocurrency. The plan would drop the algorithmic stablecoin from Terra altogether, leaving just the Luna currency. A sentiment vote conducted on Tuesday by one such holder, Terra community member “morpheus9”, returned a 92% no vote on support for the plan.

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 the 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.