“The Web as I envisaged it, we have not seen it yet. The future is still so much bigger than the past.” -Tim Berners-Lee

The market is staggeringly saturated with smart contract platforms attempting to address the blockchain trilemma. 29 smart contract platforms currently command a market capitalization greater than $1,000,000,000. Dozens upon dozens of additional platforms have failed to achieve or receded below the $1B market capitalization line. During the next 3-4 years, I expect Solana to outperform all other existing non-Ethereum smart contract platforms. Key metrics by which to quantify this outperformance include, but are not limited to: daily active account growth %, market capitalization % increase, and total value locked (TVL) growth %. Solana will outperform its competitors because its design is distinctly different from the eerily similar design choices overlapping most of the market. Let’s examine what separates Solana from the rest of the market in detail.

Monolithic Design Maximizes Composability

Nearly all competitive smart contract platforms share a design choice: modularity. Modularity is generally defined as the decoupling of one or more of the consensus, execution, and data availability layers. The modular approach attempts to solve scalability bottlenecks that have traditionally plagued Ethereum. A review of the three layers and their respective bottlenecks can be found here. Modularity is juxtaposed with monolithic design, in which the three layers remain co-located. The general definition for modularity isn’t quite broad enough, however. A few examples will demonstrate why:

Example 1: Ethereum’s roll-ups are modular because they only perform execution; consensus and data availability are retained by the main Ethereum chain. The main Ethereum chain, however, still handles execution, consensus, and data-availability. In this sense, Ethereum is monolithic and only its roll-ups are modular. Polkadot employs a slightly varied design: parachains handle execution, while the relay chain handles consensus and data availability. The technical design differences are nuanced, complex, and outside the scope of this article.

Example 2: The Cosmos blockchain attempts to achieve scalability by acting as a “blockchain of blockchains” in which many independent blockchains are interconnected via the inter-blockchain communication (IBC) protocol. In this design, scalability is achieved by building a network of fragmented, monolithic blockchains that each handle their own consensus, execution, and data availability. Avalanche’s subnets are of a similar overall design: a network of fragmented, monolithic blockchains. This design is commonly referenced as being modular in nature.

Example 3: Ethereum 2.0, Zilliqa, and Near all employ sharding techniques, in which the data layer is spread out horizontally in order to improve scalability. This technique is modular in nature, as data becomes separated from consensus and execution.

Given these examples, modularity’s common definition is far too narrow. It may be more appropriately defined as any scaling solution that is not completely monolithic i.e. any design in which execution, data, and consensus for the entire network are not all handled in the same place.

Modularity improves scaling, but replaces it with another problem: composability is hindered. Composability is the capacity for system components to be recombined into larger structures and for the output of one component to be the input of another. This is commonly referred to as “money legos.”

Multicoin Capital’s Kyle Samani provides a succinct explanation of composability and its impacts on DeFi below:

Composability enables the development of higher order decentralized finance applications that have never previously existed. For example, the UXD protocol is a novel approach to algorithmic stablecoins using Solana DEXs (Mango currently) to fully collateralize issued stablecoins 1:1 with a delta-neutral position using derivatives. These protocols are easily composable on Solana because data, execution, and consensus for both happens in the same place.

Modular designs hinder composability for several reasons:

1. Syntactic composability is the ability of dApps to integrate and interact with one another. In avalanche, as an example, it is hindered (a) between the main network and its subnets and (b) subnet to subnet. Imagine that the UXD protocol exists on one subnet and Mango exists on another subnet. Every protocol interaction must be communicated across the two subnets. Now imagine a not-yet-developed protocol that requires interaction with a dozen other protocols spread across a dozen different subnets in order to generate its desired output. Bridging messages and tokens in that scenario would utilize excessive time that is unacceptable for many financial applications and increases failure risk. While Avalanche is developing solutions for rapid bridging and communications between subnets, monolithic designs will continue to retain a significant composability edge for the foreseeable future.

2. Atomic composability, the ability to bundle multiple operations into a single transaction, is impacted in a similar manner by modularization. Assets may become stranded or lost if one operation in the transaction succeeds while another fails. This is a risk commonly discussed regarding ETH 2.0’s sharding. Solana retains complete atomic composability due to its monolithic design.

No other non-Ethereum blockchain seriously competing to become a global settlement layer employs a fully monolithic design. This unique property will serve Solana well over the next several years. Solana developers will continue to produce novel DeFi products like UXD while competitor blockchains struggle to develop complex solutions to their composability issues.

The potential of composability cannot be overstated. Some of the coming financial creations will be truly revolutionary. Solana has over 300 DeFi applications currently running or under development. As developers create novel financial products, it will attract more developers, users, and TVL. This will result in a positive-feedback loop as the network’s growth leads to the incubation of additional applications and infrastructure on Solana.

Fast, Cheap, and (Mostly) Ready Today

Solana currently executes slightly under 3,000 transactions per second (tps) with block times of 400 milliseconds. It boasts a theoretical capacity of 65,000 tps. Furthermore, these transactions cost fractions of a penny - an average of $0.00025 / transaction. Founder Anatoly Yakovenko claims eight distinct innovations make this throughput and cost/tx possible. You can read more about the technical side of Solana here. Sub-second block times are necessary to attract traditional financial institutions that require rapid settlement times that aren’t tenable on chains like Ethereum.

Solana still advertises its mainnet as a beta product, despite its $7.36B TVL. Its reliability reflects this as well, with less-than-rare periods of severely degraded performance and infrequent complete outages. On September 14th 2021, the network went down completely for 17 hours during a denial-of-service attack.

https://twitter.com/SBF_FTX/status/1485839807708385283

Investors and Solana core developers take a collectively unconcerned approach to periods of degraded performance because (1) Solana still performs more TPS than most other blockchains while degraded and (2) it’s still advertised as a beta product under development. The developers are transparent and responsive in pushing code updates to the validators after each incident.

When compared against other Layer 1s, Solana appears most ready for developers to build applications for the masses despite its periods of degraded performance. There is no scaling solution coming at some arbitrary point in the future. The protocol is (mostly) ready to scale today.

Non-EVM Ecosystem

Along with its monolithic design, Solana’s EVM non-compatibility is fairly unique. This has significant implications on the retention of resources within Solana’s network.

In EVM-compatible networks like Avalanche, protocols from Ethereum can easily be forked and deployed. Developers quickly fork previously successful protocols onto a new blockchain and collect available grant/incentive funds from that blockchain. These funds are then used to incentivize users to migrate. This historically produces cycles of mercenary capital rotation and vampire attacks, as investors and developers flow to the newest EVM-compatible blockchain with the best incentives. They then quickly move on to the next nearly-identical ecosystem once available incentives have been drained or a new blockchain offers slightly better subsidized incentives.

Solana utilizes the Rust programming language, which is substantially different from Solidity. This has several implications on retention of capital, users, and protocols:

1. Unique, successful applications built on Solana can’t easily be forked onto other blockchains. If individuals want to utilize the application, they must on-board into the Solana ecosystem. Bridging between Solana and EVM chains was originally difficult, further increasing the retention of capital and users on Solana. Bridging to and from Solana is rapidly becoming simplified and no longer poses a significant challenge to users, though.

2. Developers who dedicate time to building proficiency in Rust on Solana are far less likely to leave the ecosystem vs. Solidity developers who can jump to the next EVM chain with better incentives. With over $2,000,000,000 invested into the Solana ecosystem, I expect a magnitude increase in the number of protocols, developers, and users on Solana in 3-4 years. Those developers will be far more likely to stay working on Solana long-term compared to their peers in other ecosystems.

3. The previous discussion on composability reinforces implication #1. Solana’s composability drastically increases the capacity of developers to produce truly novel applications. Once produced, forking them to non-Solana chains is a tedious process.

*Neon Labs is bringing EVM compatibility to Solana after raising $40M in November. The alpha devnet was deployed on April 5th; beta mainnet is expected to launch in Q2. This will bring a substantial wave of Ethereum protocols and developers to Solana.

The Way Forward

Due to its monolithic composability, high throughput, low transaction cost, and fork-resistant ecosystem, I expect Solana to outperform its existing competitors over the next 3-4 years. Occasional periods of performance degradation are concerning, but the Solana core developers are transparent and continually improving the underlying code issues causing these degradation periods. With over $2B in investment into the ecosystem over the last two years, a magnitude increase in users, developers, protocols, and market capitalization is realistic across the next four years.

Beyond the 3-4 year mark, assessing the growth and dominance of Solana becomes far more challenging. To become the global settlement layer, Solana will need to handle millions of transactions per second and eventually tens to hundreds of millions of transactions per second. The demand for throughput may increase at a rate exceeding Moore’s Law, or Moore’s Law models may become dislocated from the reality of Solana’s performance increases. The space is rapidly developing and four years is sufficient time for another Solana-esque protocol to completely upend the industry overnight.

While modular blockchains may face composability issues today, thousands of developers are working to solve composability degradation across roll-ups and shards. I have high confidence that those issues will be resolved in four years time, negating any composability advantage currently held by Solana. Additionally, Solana currently lacks a convincingly clear path to achieving nation-state level censorship resistance. On a high-enough timeframe, tail risks associated with nation-state attacks on a blockchain seeking to become the global settlement layer are significant. Hardware requirements are significant and, because all validator voting occurs on chain, the voting cost for a validator is roughly 1 SOL/day (~$35,000/year). This requires a validator to own a minimum of 4,600 SOL (~$460,000) in order to break even (excluding hardware costs). This is an exorbitantly high cost to individually validate the network and is prohibitive to decentralization.

This article was originally published on April 20th, 2022. It was republished here after the wallet address for shuel.eth changed.

Terra, relentlessly guided forward by founder Do Kwon, signaled a significant adjustment of its strategic focus beginning in late March 2022. In my previous Terra analysis, I was skeptical of Terra’s long-term viability. With 74% of the total UST supply deposited in Anchor protocol, the majority of UST demand is currently recursive and unsustainable. The Chai payments partnership, which previously created modest legitimate Terra demand, is now dissolved. The Mars and Mirror protocols combined have a TVL of only 4.6% of the total UST supply.

Terra’s ecosystem still does not generate sustainable demand for 3/4 of the circulating UST supply. Anchor’s yield reserve burn rate remains in excess of $100M/month. With no evidence that Terraform Labs would successfully transition its subsidized user base to legitimate use cases before dynamic rates take effect on May 1st, the clock seemed to be running out in mid-March.

https://twitter.com/RossShuel/status/1511861439996198914?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1511861439996198914%7Ctwgr%5Ec8b80843117f0dccb246cf6aa13515f8734b9202%7Ctwcon%5Es1_&ref_url=https%3A%2F%2Fmirror.xyz%2F0x8C208E4D9a7Ed8205392a4DFc5516e68518fF4A2%2FL4g1j5I9ZFgT0cSIDVYAXg7sqmtriHvX6JylOBlyENM

Since then, the establishment of (1) the diversified strategic reserve, (2) 4Pool, and (3) Avalanche partnership have cumulatively extended Terra’s available runway to build sustainable user demand for UST. With the first strategic reserve announcement, Do Kwon revealed a shift in Terraform Labs’ strategic priority from building individual user demand to integrating Terra to cross-chain ecosystems and assets. The initial reserve announcement of $1.5B BTC was quickly raised to a $10B BTC goal. On April 1st, Do Kwon introduced the 4pool. Within a week, Terra announced a strategic partnership between the Avalanche and Terra ecosystems that will see $100M AVAX added to the strategic reserve, a Terra gaming subnet, expansion of Terra’s grants program to Avalanche protocols natively incorporating UST, and a UST-AVAX swap mechanism that will deflate the AVAX supply during periods of Terra growth. The strategic shift to cross-chain ecosystem integrations and a diversified reserve will create economic interdependence and increased user confidence that can be expected to provide volatility robustness during periods of severe economic contraction that may have previously been fatal to the protocol. Let’s examine each of the above three developments in turn:

1. Diversified Reserve

Central banks historically start from conservative positions of maximum collateralization (e.g. MakerDAO) and then evolve towards an optimal fractionalized reserve ratio that balances tail risk protection against capital efficiency. Terra’s monetary policy started at the opposite end of the spectrum. It began with zero exogenous backing and is converging towards modern monetary policy.

Modern central banks do not offer note holders 1:1 redemptions for underlying collateral. Instead, a number of financial instruments and reserve assets are employed in market making operations to ensure outstanding notes trade at an arbitrarily designated peg. In this sense, as Terra has communicated during the establishment of its strategic reserve, reserve assets are not equivalent to immediately redeemable collateral.

The Luna Foundation Guard currently holds $1.71B BTC, $398.6M USDC, $181M Luna, and $151.3M USDT in the strategic reserve for a total USD value of $2.44B. LFG continues to conduct BTC purchases and will soon add the recently announced $100M AVAX (more on this further below).

The establishment of a diversified reserve increases volatility robustness through two mechanisms:

1. Increased user confidence: As exogenous assets are added to the reserve, user confidence in UST increases disproportionality to the relatively small percentage (currently 14.1%) of the UST supply that could be redeemed for reserve assets during a peg deviation. The impact of increased user confidence on peg stability is substantial because seigniorage shares-based stablecoins are fundamentally belief-based to the extent they lack exogenous backing,.

2. Reduced economic risk: A reserve composed of centralized and decentralized assets maximizes the probability that it will preserve liquidity and thus market making capacity during future tail risk events. The strategic reserve is designed to exclusively conduct market making operations during periods of severe economic contraction that cause UST to deviate from its peg. While the strategic reserve is currently centralized in the hands of LFG’s seven directors, there is an intent to transition to decentralized, on-chain protocol custody. Market making with BTC (and eventually other assets in the reserve) is proposed to work as such:

2. 4Pool

The 4pool is a new Curve Finance pool standard that aims to bridge decentralized stablecoins with centralized stablecoins possessing off-chain liquidity. The pool will consist of UST, FRAX, USDC, and USDT. If you need a refresher on the intricacies of Curve Finance, Convex Finance, and the Curve Wars, a reader friendly introduction is available here (part 1) and here (part 2).

https://twitter.com/stablekwon/status/1510021707377287170?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1510021707377287170%7Ctwgr%5Ec8b80843117f0dccb246cf6aa13515f8734b9202%7Ctwcon%5Es1_&ref_url=https%3A%2F%2Fmirror.xyz%2F0x8C208E4D9a7Ed8205392a4DFc5516e68518fF4A2%2FL4g1j5I9ZFgT0cSIDVYAXg7sqmtriHvX6JylOBlyENM

With a massive $21.38B TVL, Curve plays a fundamental role in stablecoin stability for those that possess the requisite influence over CRV emissions needed to attract deep liquidity. To eventually establish the 4pool across all EVM chains, Terra has entered into a 3-way partnership with FRAX and Redacted Cartel. Previously, FRAX and Terra competed against one another for CRV and CVX emissions through votium incentives and vlCVX votes as the two largest DAO holders of CVX. Terra added 605,222 CVX to its holdings in the past week, passing up FRAX to become the top DAO holder of CVX with total holdings of 2,270,406 CVX. FRAX comes in just behind Terra, currently holding 2,229,603 CVX. Redacted Cartel holds 1,502,995 CVX. Combined, the partnership currently owns 10.4% of the circulating CVX supply. While not hegemonic, the partnership’s CVX supply ownership is sufficiently adequate to build deep 4pool liquidity and is still growing with weekly increases in their collective holdings. With the above in mind, the 4pool will improve UST’s peg resilience through several mechanisms:

1. Deep Curve pool liquidity = stability: Until now, UST has primarily resided in the UST+3Crv pool, which has $1.3B of liquidity. This pales in comparison to 3pool’s $3.6B of liquidity. Do Kwon has clearly signaled he intends to kill 3pool and replace it with 4pool, stealing away DAI’s Curve liquidity. With 10.4% of CVX under the Terra-FRAX-RC partnership’s control, this is a realistic possibility pending MakerDAO’s response. Assuming that the 4pool achieves the liquidity depth of the 3pool, a minimum of a 270% increase in trade volume will be required to deviate UST’s peg on Curve compared to the current UST+3Crv pool. Notably, I have only listed Ethereum’s Curve liquidity. Terra intends to expand the 4pool to every EVM chain that Curve is currently on.

2. Integration of UST into FRAX AMOs: FRAX v2 employs Algorithmic Market Operations Controllers (AMOs), which are contracts that carry out arbitrary monetary policy. So long as they submit to FRAX’s base mechanism rules and do not cause peg deviation, any AMO design can be approved. An example of what an AMO might look like can be found here. FRAX governance votes on AMO proposals for implementation, allowing nearly unlimited flexibility for the market operations FRAX can perform. The current Curve AMO’s structure opens the pathway for UST to become FRAX collateral, intertwining the two protocols and, as a result, improving the peg resilience of both FRAX and UST. Terra stated during its 4pool announcement, “stablecoin pegs are stronger together than competing against one another.” The 4pool partnership will lead to brand new AMO strategies that take advantage of Terra’s size and continued growth.

3. Composability: As the 4pool grows in size, the inherent composability of Curve will lead to new DeFi primitives and strategies that integrate UST (via its yield bearing 4pool token) into other layer 1s and protocols. As other protocols become dependent upon the 4pool’s LP token, they will provide another vector for stabilization via demand during future periods of economic contraction. This will simultaneously reinforce the relationship between the 4pool’s underlying assets.

   *The Average Joe’s Crypto explains Do Kwon’s qualms with DAI and 4pool’s impact on MakerDAO in detail here. The MakerDAO-Terra relationship is beyond the scope of this article.

3. Avalanche Partnership

https://twitter.com/stablekwon/status/1512291560171311108?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1512291560171311108%7Ctwgr%5Ec8b80843117f0dccb246cf6aa13515f8734b9202%7Ctwcon%5Es1_&ref_url=https%3A%2F%2Fmirror.xyz%2F0x8C208E4D9a7Ed8205392a4DFc5516e68518fF4A2%2FL4g1j5I9ZFgT0cSIDVYAXg7sqmtriHvX6JylOBlyENM

On April 7th, Avalanche and Terra announced a three-pronged partnership to integrate each ecosystem’s native assets in a multi-layered approach, explained below.

1. AVAX reserves: Terra will add $100M of AVAX to its strategic reserve. Users will be able to swap UST<>AVAX through a mechanism similar to the BTC redemption diagram shown earlier. Users wanting UST will be able to swap $1 of AVAX for 1 UST, and users wanting AVAX can swap in 1 UST for $0.99 of AVAX. This pricing asymmetry ensures the reserve only conducts market making during periods of peg deviation. This reserve creates a mint/redemption mechanism for UST native to the Avalanche blockchain. Additionally, the quantity of AVAX held by the reserve will increase as UST demand increases on Avalanche. The continual removal of AVAX from the circulating supply will have a deflationary effect, so long as UST growth > contraction on the Avalanche blockchain.

2. Terra grants program: During a recent fireside chat with Emin Gün Sirer of Ava Labs, Do Kwon announced Avalanche’s eligibility for Terra’s grants program. Any project building on Avalanche that natively integrates UST is eligible for grant funding to off-set audit costs, initial bootstrapping costs, etc. Neutralization of set-up costs will enable more community-owned launches, rather than forcing protocols to raise funding. As more protocols integrate UST in order to claim grant funds, demand for UST on Avalanche will increase, and more AVAX will be removed from the circulating supply. Economic incentives are well aligned in this partnership, so long as UST’s overall growth > contraction. Should UST face a significant de-peg scenario, economic incentives will become net negative as Avalanche users rush to redeem their UST for $0.99 of AVAX.

3. Gaming subnet: Terra will launch a gaming subnet on the Avalanche blockchain in the near future. I expect to see UST deeply integrated within this subnet, likely used as gas for transactions. This subnet, if successful, will further increase (1) AVAX demand as each subnet validator must own 2,000 AVAX in order to also validate the main network and (2) Avalanche-native UST demand as the subnet increases in popularity.

*The term Avalanche “native” UST only means that there is a swap mechanism for AVAX<>UST directly on the Avalanche blockchain for which the liquidity is owned by the Terra protocol. Per the Terra blockchain’s design, Terra (UST) can only be minted by burning LUNA on the Terra blockchain via the LUNA<>UST mint/burn seigniorage mechanism. All swap mechanisms with the strategic reserve are nothing more than specialized virtual AMMs. Thus, UST is only truly native to the Terra blockchain; it must be bridged to all other blockchains (via Wormhole v2 currently). This somewhat misleading language is used by Do Kwon and Terra, so I have decided to continue to use it within this article for continuity.

Outlook

Seignorage-shares based stablecoins are fundamentally belief-based systems to the extent they lack exogenous collateral or backing. If all economic incentives are related to rewards endogenous to the system itself, it is at risk of collapse should severe and protracted economic conditions shake users’ belief in the peg. With this in mind, sustainable monetary policy for an algorithmic stablecoin requires two primary considerations:

1. Appropriate design mechanisms and economic incentives to stabilize the currency’s peg.

2. Sustainable economic demand for the currency within its respective economy, external to consideration #1.

Terra has previously focused on the second consideration, seeking to develop a thriving ecosystem around UST that drives sustainable demand and, therefore, provides stability. It has failed to do so thus far. Terra has now heavily shifted its strategic focus to point #1, actively creating more runway to build sustainable economic demand before a tail risk event occurs.

Short-to-medium term assessment

At the current pace and in alignment with Do Kwon’s vision to make Terra the decentralized money of all blockchains, I expect Terra to announce similar major partnerships with other layer 1s by the end of Q2. In addition to all of the above mechanisms stabilizing the peg, venture capitalists invested in the protocol have significant economic incentive to ensure the peg’s resilience. I believe most Terra skeptics severely underestimate the exposure firms such as Jump have to LUNA. As a result, they severely underestimate the willingness of those firms to step in as market makers of last resort to ensure any peg deviation is recovered. Due to VC economic incentives, the recently established strategic reserve, and the various ecosystem integrations described above, I fully expect Terra to rapidly recover any peg deviation that occurs in the short-to-medium term, with the exception of a tail risk event.

Long term assessment

Over the long-term, I remain deeply skeptical of the Terra protocol’s viability. Terra, per its original design, has no reserve backing or exogenous collateral. The addition of a strategic reserve as an afterthought requires human estimation of the appropriate reserve ratio required to sustain peg confidence through tail risk volatility. Changes to the reserve ratio and market making design mechanisms are slow and cumbersome, requiring decentralized proposal, approval, and implementation. In Terra’s afterthought reserve design, the principles of decentralization and immutability work against the protocol rather than for it. This is juxtaposed against designs such as the FRAX protocol, which allows real-time market forces to continuously determine and re-adjust the appropriate collateral ratio required to maintain peg confidence amidst dynamic economic conditions.

Scenario 1: Envision a sudden, severe economic contraction occurs that causes the BTC<>UST mechanism to conduct market making in order to recover the peg. Community members realize the daily cap on BTC<>UST swaps* is insufficient to rapidly recover the peg. A proposal to increase the daily swap cap is proposed and voted on. While the on-chain vote period persists, BTC swaps are unavailable. During that 24-hour period, Terra becomes highly reflexive as capital seeks to flee the ecosystem via off-chain UST swaps. UST drops below $0.50 and LUNA’s market capitalization rapidly drops towards zero.

*The particular details of daily redemption caps, proposal vote details, etc. are not yet set, but I expect a daily redemption cap of some kind per Jump’s design proposal.

Scenario 2: Envision a sudden, severe economic contraction occurs that causes the BTC<>UST mechanism to conduct market making in order to recover the peg. Community members realize the daily cap on BTC<>UST swaps is insufficient to rapidly recover the peg. A proposal to increase the daily swap cap is put forth and voted on. The vote fails due to some unforeseen reason. UST develops an exponential price trend from $1.00 down to $0.89 during the 7-day period that strategic reserves are still available. On the 8th day, the last strategic reserves are depleted and UST races to zero as investors and speculators swiftly exit their positions via off-chain swaps.*

*LUNA/UST on-chain swaps would also occur to the swap rate-determined maximum during scenarios such as these, infinitely diluting LUNA and driving its price down. AVAX and any other strategic reserve assets available for swaps above market rate would also be swapped to the daily maximum cap in these scenarios.

In both of these scenarios, flawed human assessments that lag behind dynamic market conditions are inadequate to maintain peg confidence. Terra, by design, is unable to modify its reserve ratio at the same pace that tail risks emerge. On a long-enough timeframe, the probability that Terra eventually underestimates the reserve ratio required to ensure UST peg confidence is 100%. When the protocol’s reserve ratio is insufficient to maintain peg confidence amidst a tail risk event - when severe, protracted, global risk-off conditions crush all of crypto - Terra’s reflexive design will pose an existential risk. At that point, all of Terra’s cross-chain ecosystem integrations will cease to bolster the peg and transition to liabilities on Terra’s respective partners, unwinding the health of the entire crypto ecosystem.

This article was originally published on Medium on March 24th, 2022.

Like blockchain protocols, stablecoins face their own trilemma, commonly defined as a constraint to a maximum of two of the following three: decentralization, stability, and capital efficiency. Custodial stablecoins such as USDC, USDT, and Paxos are highly stable and capital efficient with a 1:1 collateral ratio, but achieve this at the cost of centralization. Non-custodial, on-chain collateralized stablecoins such as MakerDAO’s DAI achieve stability and decentralization at the cost of capital efficiency. The volatile assets composing the collateralized debt positions (CDP) referred to as vaults require over-collateralization in excess of 150%. MakerDAO additionally exchanges a large degree of decentralization for volatility robustness. 34% of all DAI are collateralized by USDC currently. Should USDC collateralization continue to increase, DAI risks evolution into a synthetic USDC. (The USDC backing in MakerDAO is technically a swap rather than a CDP, but this technical differentiation is beyond the scope of this article).

Seigniorage shares stablecoins are the primary category of algorithmic stablecoins attempting to solve the stablecoin trilemma by employing monetary contraction and expansion mechanisms, backed by partial or completely endogenous collateral, to achieve decentralization and capital efficiency. To the extent they lack exogenous collateral, all seigniorage shares-based stablecoins are fundamentally belief-based systems. When all economic incentives for stability are tied to rewards endogenous to the system itself, a protocol is at risk of losing stability should protracted or severe volatility shake users’ belief in the stablecoin’s peg. This inherent attribute of algorithmic stablecoins has caused deep disagreement amongst developers, founders, and investors regarding long-term viability.

https://twitter.com/RuneKek/status/1478166276979793922?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1478166276979793922%7Ctwgr%5E7a8ac21889e4b12cf847a0dfd59e606ec28d6bc1%7Ctwcon%5Es1_&ref_url=https%3A%2F%2Fmirror.xyz%2F0x8C208E4D9a7Ed8205392a4DFc5516e68518fF4A2%2F8JB_eVBAMYDw0PeCMAZIZdS0Ao7m4Fxcoh1zprKfoXo

Due to this belief-based system, seigniorage stablecoins demonstrate reflexivity, amplifying directional movements and placing them at risk of entering into a “death spiral” as loss of user confidence amidst economic contraction feeds into a destructive, positive-feedback loop.

The seigniorage model is the evolution of monetary policy via code, employing various mechanisms to contract and expand the money supply in accordance with market conditions while continually absorbing volatility in order to maintain the peg. Just as civilization’s history is strewn with the corpses of nation states that employed reckless or untenable monetary policy, so too will crypto history be strewn with the corpses of seigniorage stablecoins that failed to provide adequately robust protections against volatility amidst periods of severe and protracted contraction.

Terra

The Terra protocol is an open-source, public blockchain built on the Cosmos SDK and designed around its algorithmic stablecoin, Terra. It was incepted by Do Kwon in 2018. There are two main token pools within the Terra protocol:

1. Terra: These are fiat-tracking stablecoins, pegged 1:1 to their respective currency and minted by burning Luna. Terra is designed to be stabilized at a 1:1 peg via an elastic coin supply. Multiple denominations exist and all occupy a single pool. At the time of writing, total supply of Terra by denomination is broken down as follows. TerraUSD’s (UST) supply is 15,387,670,000. TerraKRW’s (KRT) supply is 36,867,150,000 ( $ 30,231,063). Terra’s Mongolian tugrik’s (MNT) supply is 216,300,000 ( $ 73,542). The base Terra stablecoin, TerraSDR (SDT), which tracks the International Monetary Fund’s Special Drawing Rights (SDR), has a current supply of 700,100,000 ( $ 407,822,252). All other existing Terra stablecoins are negligible in quantity. 97.2% of all value in the current Terra supply is captured by UST. With that in mind, I will use Terra and UST interchangeably going forward.

2. Luna: Luna is the native Terra blockchain token, staked by network validators in order to secure the network. Transaction fees on the Terra blockchain are paid to validators in Luna (Validation/Mining are largely irrelevant to this article’s analysis. More information on Tendermint consensus on the Cosmos SDK can be found here and specific application of the consensus protocol on Terra can be found here). Luna is the share component within the Terra blockchain’s seigniorage shares model, utilized to absorb volatility and stabilize the coin component (UST). At the time of writing, there is a total supply of 720,100,000 LUNA, down from the genesis creation of 1 Billion LUNA.

$1 value of LUNA can ALWAYS be exchanged for 1 UST, and vice-versa, via the protocol’s mint and burn mechanism. Stabilization of UST is proposed to work via the following:

Expansion: When demand for UST increases, UST will begin to trade above the $1 peg. Arbitragers are then able to burn $1 of LUNA in order to mint 1 UST and trade it. This process will continue until the peg is regained. This expands the money (UST) supply and decreases the LUNA supply during periods of economic growth within the Terra ecosystem. As the Terra ecosystem grows and demand for UST causes a decrease in the LUNA supply, LUNA should be expected to grow in value. Of note, following the Columbus-5 upgrade in September 2021, 100% of LUNA is now burnt by the protocol when minting UST, which makes Terra technically no longer a seigniorage stablecoin.

Contraction: When demand for UST decreases, the price will trade below the $1 peg, indicating that the money supply needs to contract. Arbitragers are then able to burn 1 UST and mint $1 of LUNA, in a reversal of the expansion process. This process absorbs UST’s volatility by diluting LUNA holders. Monetary contraction is never cost-free. 41.03% of all LUNA is currently staked, implying that Terra validators burden a substantial portion of short-term dilution during periods of economic contraction, in the hope that medium-to-long term ecosystem growth will result in greater incentives. Furthermore, LUNA can theoretically be infinitely diluted, though this is limited by on-chain liquidity parameters that exponentially increase the swap spread beyond a certain quantity (explained further in May 2021 peg deviation analysis further below).

The Great Filter

The Fermi Paradox is a scientific observation that originated amongst a number of prominent physicists in the 1950s. It contends with the lack of alien life evidence given the high probability estimate for it, based upon the universe’s age and size. Economist Robin Hanson attempted to address the paradox by introducing The Great Filter in 1995. He proposed that amongst the evolutionary steps required for a species to advance adequately far enough to colonize the universe, passage of at least one of those steps must be highly improbable, otherwise the universe would be replete with highly-advanced, colonizing species. At the improbable step(s), the universe ruthlessly filters and eviscerates species from the cosmic timeline. If a species successfully passes through the great filter, they will achieve long-term, sustained existence.

The great filter is an analogously appropriate lens through which to assess seigniorage stablecoins seeking to solve the stablecoin trilemma. However, unlike humanity’s future, the reflexive design of seigniorage stablecoins reveals the improbable evolutionary step — the great filter — that determines long-term viability. The great filter of seigniorage stablecoins is highly severe and protracted economic contraction, such as that seen in historical financial crises. The market, much like the universe, is indifferent and unforgiving. Just as in the case of humanity’s future, there are no second chances for stablecoins to pass through the great filter. While decentralization may exist on a spectrum, stablecoin survivability is binary. Algorithmic stablecoins either possess the requisite stability mechanisms to recover any peg deviation arising during market dislocations or they are likely to die.

The whole of crypto remains a speculative, risk-on asset class in 2022. It has never experienced protracted, global, risk-off market conditions such as those in the aftermath of the 2008 financial crisis. Should similar conditions arise before crypto deeply integrates into global financial infrastructure, crypto can be expected to contract faster and more severely than any other asset class. Illiquidity and despondency will drown out all other narratives as both speculators and investors flee to higher financial ground. Is Terra capable of surviving such conditions for a multi-year period?

Ecosystem Development and Token Demand

Terraform Labs raised $150M in July 2021 in order to further develop a burgeoning ecosystem intended to create legitimate, perpetual demand for the Terra stablecoin. The team has clearly communicated their strategic approach to Terra’s ecosystem in the past, betting on legitimate use cases and demand for UST resulting in price stability.

https://twitter.com/terra_money/status/1396780943516467211?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1396780944921567232%7Ctwgr%5E7a8ac21889e4b12cf847a0dfd59e606ec28d6bc1%7Ctwcon%5Es2_&ref_url=https%3A%2F%2Fmirror.xyz%2F0x8C208E4D9a7Ed8205392a4DFc5516e68518fF4A2%2F8JB_eVBAMYDw0PeCMAZIZdS0Ao7m4Fxcoh1zprKfoXo

Anchor Protocol:

Anchor is the cornerstone of the Terra ecosystem. It is advertised as a ‘decentralized savings’ protocol that pays a consistent 19.4% yield on UST. The protocol differs from a typical money market such as Aave in that all collateral must be yield-bearing assets, referred to as ‘bonded’ assets within the protocol’s documentation. These bonded assets represent staked assets in proof-of-stake protocols, providing consistent yield. As of now, the bonded versions of staked LUNA, ETH, and AVAX are the only assets available to be utilized as collateral within the protocol. Terraform Labs claims that the use of interest bearing collateral enables the high yield on deposited UST.

Anchor recently expanded its reach to Avalanche, enabling seamless bridging of assets from Avalanche to Terra through Wormhole via an extension the team calls xAnchor. I almost didn’t recognize my UST was bridged from Avalanche to Terra through the app during my first interaction. With no requirement to interact with Wormhole or Terra aside from an approval transaction, most users won’t even know their assets are leaving the Avalanche chain. Terra Station wallet is not required. No understanding of bridging is required. This is the seamless and simple user experience Terraform Labs consistently speaks about. As Terraform Labs continue to expand to other chains, demand for UST can be expected to grow substantially so long as the 19.4% yield remains stable.

https://twitter.com/ryanology045/status/1504311692339343365?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1504311692339343365%7Ctwgr%5E7a8ac21889e4b12cf847a0dfd59e606ec28d6bc1%7Ctwcon%5Es1_&ref_url=https%3A%2F%2Fmirror.xyz%2F0x8C208E4D9a7Ed8205392a4DFc5516e68518fF4A2%2F8JB_eVBAMYDw0PeCMAZIZdS0Ao7m4Fxcoh1zprKfoXo

19.4% yield on a stablecoin is deeply unaligned with the yields available in other money markets such as Aave, Yearn’s Iron Bank, Benqi, Scream Finance, Blizz Finance, and Trader Joe. The protocol pays UST lenders from collateral staking yields and UST borrower interest rates. During risk-on market conditions when borrowers pay higher rates, it is theorized that lender yield < collateral staking yield + borrower interest rates. This excess contributes to a yield reserve, which currently contains 401,225,046 UST. During lowered borrowing demand, such as much of the past year, this reserve can be drawn upon in order to ensure the 19.4% yield. The yield reserve ran a $100M deficit during the last 30 days.

Terraform Labs has previously stepped in to replenish the yield reserve during extended periods of lowered borrowing demand, with the second injection of $450M in February bringing the total to $520M.

https://twitter.com/anchor_protocol/status/1412614294185943043?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1412614294185943043%7Ctwgr%5E7a8ac21889e4b12cf847a0dfd59e606ec28d6bc1%7Ctwcon%5Es1_&ref_url=https%3A%2F%2Fmirror.xyz%2F0x8C208E4D9a7Ed8205392a4DFc5516e68518fF4A2%2F8JB_eVBAMYDw0PeCMAZIZdS0Ao7m4Fxcoh1zprKfoXo

While conversations about lowered, dynamic yield rates to ensure protocol solvency have occurred, there is no evidence that Anchor will actually abandon its 19.4% yield in the near future. The past year has demonstrated that on a high-enough timeframe, the occurrence of yield reserve depletion due to a sufficiently protracted market draw-down is a probabilistic certainty when yields remain fixed. Terraform Labs is making a convicted bet — $520M thus far — that some critical mass of users necessary to create Terra ecosystem sustainability can be generated through subsidized, stable yield.

https://twitter.com/stablekwon/status/1503154137420079107?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1503154137420079107%7Ctwgr%5E7a8ac21889e4b12cf847a0dfd59e606ec28d6bc1%7Ctwcon%5Es1_&ref_url=https%3A%2F%2Fmirror.xyz%2F0x8C208E4D9a7Ed8205392a4DFc5516e68518fF4A2%2F8JB_eVBAMYDw0PeCMAZIZdS0Ao7m4Fxcoh1zprKfoXo

Yields on Anchor will eventually re-align with the wider market when the yield reserve is permanently depleted and Anchor (ANC) emissions stop incentivizing borrowing. Assuming a generous 9% yield on all staked collateral, Anchor currently generates $517M annual yield on collateral and an additional $320M via UST borrowing interest (at current 11.57% APR), for annual income of $837M. With over 11 Billion UST deposited, Anchor is currently paying out $2.23B in annual yield. While protocol liabilities and assets will continue to fluctuate over time, they can be expected to only further increase Anchor’s deficit. The historical trend is exceptionally clear. Total UST deposits are increasing at a rate far greater than that of total borrows (borrow rates are directly linked to the rate of change in collateral deposits) as speculators continue to swoop in to take Terraform Labs’ freely offered money.

With the above assumptions in play, the protocol would have to pay under 8% on UST deposits to maintain solvency with its current assets and liabilities. The yield rate could settle in a range slightly above 8% as UST deposits decrease in response to decreasing yield, but the 15–16% yield rate claimed by Do Kwon is not realistically sustainable. There is only one reason to pay 11.57% to borrow UST rather than the current 3–5% market rate for other stablecoins; you can earn 19.47% yield on the UST you’ve just borrowed. This recursive demand for UST is unhealthy and precisely what Do Kwon has spoken out against in the past. When yield begins to drop, the borrow demand can also be expected to plummet.

https://twitter.com/stablekwon/status/1405742209106812938?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1405742211396882434%7Ctwgr%5E7a8ac21889e4b12cf847a0dfd59e606ec28d6bc1%7Ctwcon%5Es2_&ref_url=https%3A%2F%2Fmirror.xyz%2F0x8C208E4D9a7Ed8205392a4DFc5516e68518fF4A2%2F8JB_eVBAMYDw0PeCMAZIZdS0Ao7m4Fxcoh1zprKfoXo

As Anchor yields begin to align with the wider market, investors and speculators can be expected to rapidly move back into exogenously collateralized stablecoins assessed to be lower risk. So long as custodial stablecoins are not facing imminent regulatory risk and Circle is solvent, USDC and other collateralized stablecoins such as DAI will remain the obvious choice for users that prioritize returns and risk minimization over philosophical dedication to decentralization. As both yield and borrowing demand begin to drop , it is highly probable that a bank run on Terra could occur given that 73.4% of the total UST supply is currently concentrated in Anchor.

CHAI:

In June 2019, Terraform Labs partnered with CHAI, a Korean mobile payments company founded by Terra co-founder Daniel Shin. The integration of Terra into the CHAI ecosystem enables purchases with reduced transaction fees for merchants. Prior to the Columbus-5 upgrade, a portion of seigniorage was dedicated to incentivizing CHAI users with discounts at participating merchants. Within the CHAI app, users pay with South Korean Won (KRW) which is converted to KRT, transacted to the merchant’s Terra wallet, and then converted back to KRW. The process occurs in the background, not exposing users and merchants to the underlying payment rails. Fees are reduced from 2–3% to <1% by utilizing Terra’s blockchain. Juxtaposed against Anchor, real-world payment integrations such as CHAI generate legitimate and sustainable demand for UST.

Users must elect to use Terra within the CHAI app. The millions of Korean consumers that have the CHAI app and card are not transacting with Terra by default. In an attempt to look into details regarding KRT demand via CHAI, I went to chaiscan.com, which was established as a block explorer-style analytics suite for Terra-specific CHAI payments. It has been defunct for at least the last 96 hours.

I then discovered this article, in which a CHAI card holder was reportedly informed by customer service that the partnership between Terra and CHAI was discontinued, effective as of September 2021. When I reached out directly to CHAI via e-mail to confirm this information and request more detailed information regarding the underlying transaction flow that Terra uses in the CHAI app, they responded:

Despite the discontinuation of Terra’s partnership with CHAI, there has been no significant decline in KRT transaction volumes. As shown below, the cumulative KRT transaction volume has maintained a nearly constant rate of increase since 2020 Q3. This linear relationship reveals stagnation over the last 1.5 years, without any significant transaction volume growth since the initial CHAI integration period ended.

If CHAI was on-boarding a significant number of active Terra wallet users, a sudden, pronounced decline in daily volumes should be present in the below chart at the time the integration ended. The absence of a sharp volume decline casts doubt on CHAI’s impact towards on-boarding users. Terraform Labs has not yet made any public acknowledgment or confirmation of the terminated CHAI partnership.

May 2021 Peg Deviation, Recovery, and Subsequent Protocol Improvements

Following the sell-off in early May 2021 during which BTC declined 45% over two weeks, UST temporarily deviated from its peg for several days. The UST total supply contracted 9.5% from 2.1 Billion to 1.9 Billion over a week period.

The market-wide sell-off caused excessive liquidations of bLUNA in the Anchor protocol, amplifying the directional movement of LUNA. When a slight peg deviation developed, traditional arbitrage methods were unable to close the gap due to on-chain liquidity parameters.

Terra’s oracle design for pricing the on-chain UST/LUNA swap mechanism requires consensus on the exogenous, off-chain LUNA price. If off-chain liquidity < on-chain liquidity, then the off-chain LUNA price can be intentionally bid up, allowing on-chain swaps to UST of a greater (profitable) quantity using the bid up price. The reverse then happens as exogenous prices are bid down and manipulators swap back to LUNA. In order to prevent this type of oracle attack, off-chain liquidity must always be greater than on-chain liquidity. Thus, general on-chain parameters prior to the May 2021 peg deviation allowed for up to $20M in swaps at a 2% spread each day. Beyond $20M, the spread begins to increase exponentially. This effectively limits on-chain liquidity, preventing the oracle attack described above. 1 UST is still swapped for $1 LUNA under these parameters, but the spread is paid to Terra miners as a “tax”.

The trade-off in implementing these parameters is that arbitrage becomes unprofitable if the peg is not quickly regained, due to the spread’s exponential increase beyond $20M. The on-chain liquidity parameters exacerbated the duration and severity of the peg deviation, with the swap spread at 500–700bps for most of the episode. This likely caused further loss of confidence and price decrease as users looked to exit UST and LUNA positions via off-chain markets when arbitrage was no longer profitable. Furthermore, circulating LUNA value dropped below UST value on 23 May, rendering the protocol insolvent. While LUNA can be infinitely diluted so long as it trades above $0, user confidence is further shaken when there are no longer enough assets to cover liabilities.

https://twitter.com/aklamun/status/1396615719228424196?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1396615719228424196%7Ctwgr%5E7a8ac21889e4b12cf847a0dfd59e606ec28d6bc1%7Ctwcon%5Es1_&ref_url=https%3A%2F%2Fmirror.xyz%2F0x8C208E4D9a7Ed8205392a4DFc5516e68518fF4A2%2F8JB_eVBAMYDw0PeCMAZIZdS0Ao7m4Fxcoh1zprKfoXo

Despite all of the above issues, dislocated arbitrage incentives slowly re-aligned over several days and enabled the protocol to re-establish its peg, which it has maintained since. The 21-day lock-up period for the 33.6% of the total LUNA supply that was staked at the onset of this episode provided much needed stability. Additionally, Anchor protocol’s uninterrupted yield on UST deposits maintained a baseline demand for UST.

https://twitter.com/stablekwon/status/1396810206391070720?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1396810206391070720%7Ctwgr%5E7a8ac21889e4b12cf847a0dfd59e606ec28d6bc1%7Ctwcon%5Es1_&ref_url=https%3A%2F%2Fmirror.xyz%2F0x8C208E4D9a7Ed8205392a4DFc5516e68518fF4A2%2F8JB_eVBAMYDw0PeCMAZIZdS0Ao7m4Fxcoh1zprKfoXo

Terra’s capacity to re-establish its peg after a relatively severe market-wide contraction is a hopeful nod to Terra’s long-term viability. In a post-mortem analysis, Jump Trading introduced Prop 90 to adjust on-chain liquidity parameters in a bid to improve Terra’s volatility absorption during future market contractions. It effectively increased on-chain redemptions to $100M with lower spreads.

https://twitter.com/terra_money/status/1397397487338631169?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1397397489213485057%7Ctwgr%5E7a8ac21889e4b12cf847a0dfd59e606ec28d6bc1%7Ctwcon%5Es2_&ref_url=https%3A%2F%2Fmirror.xyz%2F0x8C208E4D9a7Ed8205392a4DFc5516e68518fF4A2%2F8JB_eVBAMYDw0PeCMAZIZdS0Ao7m4Fxcoh1zprKfoXo

UST FOREX Reserve

In February, the Luna Foundation Guard (LFG) announced a $1B private LUNA token sale in order to build a reserve of decentralized, non-correlated assets as an additional mechanism to reduce UST’s reflexivity during periods of contraction. During exceptionally volatile periods, such as May 2021, users will be able to swap a 1:1 ratio of UST for $1 of the non-correlated, decentralized assets held by LFG. This reserve will likely act as a safety valve during periods when on-chain liquidity parameters inhibit arbitragers from maintaining UST’s peg. The initial reserve will consist of BTC, but the LFG intends to expand the reserve to other non-correlated, decentralized assets in the future. Do Kwon has communicated plans to grow the reserve to 10B going forward.

https://twitter.com/stablekwon/status/1503296630396645376?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1506274220048887810%7Ctwgr%5E7a8ac21889e4b12cf847a0dfd59e606ec28d6bc1%7Ctwcon%5Es2_&ref_url=https%3A%2F%2Fmirror.xyz%2F0x8C208E4D9a7Ed8205392a4DFc5516e68518fF4A2%2F8JB_eVBAMYDw0PeCMAZIZdS0Ao7m4Fxcoh1zprKfoXo

In addition to BTC’s legitimate capacity to provide volatility absorption as an asset of last resort, introduction of exogenous collateral reserves profoundly alters user perceptions. User confidence in the protocol increases disproportionally to the relatively small percentage of outstanding UST that can actually be redeemed for BTC.

The Way Forward

While Terra’s BTC reserve and May 2021 recovery are positive indicators, I am skeptical of the protocol’s long-term viability. The May recovery is partially attributable to demand sustained throughout the episode via Anchor’s 19.4% yield. This yield creates artificial, recursive demand that I find highly concerning. At a current burn rate of $100M/month and with no evidence that Terraform Labs is successfully transitioning its subsidized user base to legitimate use cases, the clock is running out. When Anchor’s yield can no longer be subsidized and dissipates away, so too will the market’s ephemeral demand for the 73% of the UST supply currently deposited in Anchor. When Terra finally passes through the great stablecoin filter — when protracted, severe, global risk-off conditions crush all of crypto — I do not have confidence that Terra will survive without legitimate token demand. As Iron Finance demonstrated, partially-exogenous collateral is no guarantee of stability. A scenario in which LUNA trends to zero and never recovers while all outstanding UST drop to the BTC reserve backing is a realistic outcome for the market conditions described above. Protracted risk-off conditions such as those described above will either kill the Terra protocol or provide an extremely risk-minimized opportunity to invest in a steeply discounted algorithmic stablecoin with proven survivability. Reconsideration of this assessment would require legitimate use cases such as CHAI payments and Mirror Protocol to account for a majority of UST demand and/or an appropriate change in the regulatory treatment of custodial stablecoins.