Are Algorithmic Stablecoins Dead Already? A Full Breakdown of the Terra Crash
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Are Algorithmic Stablecoins Dead Already? A Full Breakdown of the Terra Crash

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CoinMarketCap Alexandria takes a look at the rise, and fall, of algorithmic stablecoins — and what the future holds for this stablecoin model.

Are Algorithmic Stablecoins Dead Already? A Full Breakdown of the Terra Crash

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In the search for stability on the blockchain, a wide variety of stablecoin models have emerged — each of which has its pros and cons. Though fiat-backed stablecoins remain the most dominant, a new wave of algorithmic stablecoins has emerged in recent years, each of which hopes to provide a more decentralized price-stable asset.
As algorithmically stabilized assets, algorithmic stablecoins are different from simple asset-backed stablecoins in that they generally rely on algorithms, game theory and economic incentives to maintain their peg. This means they don’t need to rely on centralized issuers and treasuries to maintain their value but also leaves them potentially vulnerable to economic attacks — making it easier to knock them off peg.

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The Rise of Algorithmically Stable Cryptocurrencies

As the cryptocurrency industry strives for further decentralization, stablecoins remained one of the last pieces of the puzzle to be moved to a fully decentralized system, since almost all popular stablecoins relied on centralized issuers holding fiat reserves.

This, some would argue, poses a systemic risk to the cryptocurrency industry as a whole, since stablecoins are responsible for more than half of all cryptocurrency trading volume and are crucial to the stability of the industry right now.

Algorithmic stablecoins promise myriad benefits over typical fiat-backed stablecoins, including being fully decentralized. Since these coins didn’t rely on traditional companies and do not require a direct link with fiat currency, this can make them more difficult to shut down, regulate, or seize. They’re also much quicker to bootstrap and scale, since any team with an idea and minimal resources and collateral can build and deploy an algorithmically stabilized token in just days in many cases.

Since algorithmically stabilized cryptocurrencies are completely on-chain, they can also be considered more transparent than fiat-backed stablecoins, since only some of these publish credible audits of their reserves and relatively infrequently at that.
Nonetheless, despite these clear benefits, algorithmic stablecoins only began to pick up attention with the release of TerraUSD (UST) — a dollar-pegged stablecoin for the Terra blockchain. This, in combination with the decentralized savings platform known as Anchor Protocol (which provided a fixed 20% APY) proved to be incredibly popular and saw its uptake explode between March 2021 to May 2022.
There is now a growing list of algorithmic stablecoins, with several now available on most popular smart contract platforms, though most are still relatively obscure and poorly adopted.

The Downfall of Algorithmic Stablecoins

Unlike typical fiat-backed stablecoins, which can generally be redeemed at a 1:1 rate for actual fiat held in reserves, algorithmic stablecoins are not directly backed by a price-stable asset.

Instead, they can vary quite widely in the mechanism they use to achieve stability. While this can work out relatively well in some cases, other times it is a ticking time bomb just waiting to explode.

Since most algorithmic stablecoins rely on arbitrage mechanisms to maintain stability, they generally rely on a volatile secondary token at some point in their re-pegging cascade. If this secondary token becomes extremely undesirable or has strong selling pressure, it can cause the whole system to unwind.

This has left many algorithmic stablecoins particularly vulnerable to black swan events or intentional market manipulation, both of which can knock the stablecoin off peg, and in some cases collapse it entirely.

The Case of TerraUSD

TerraUSD (UST) is an algorithmic stablecoin designed to maintain its peg through on-chain arbitrage activity.

Through the Terra Station wallet, users are able to swap 1 UST for $1 worth of LUNA at any time. Theoretically, if UST were to drop below its $1 peg, users could simply exchange it for $1 worth of LUNA, which they could then sell for $1. Meanwhile, the supply of UST would contract and demand for the token on secondary exchanges would increase as users look to take advantage of the arbitrage opportunity — driving the value of UST back up to $1.

However, this system was put to the test in May 2021, when TerraUSD experienced one of the worst deviations from its peg in its short history — after collapsing from $1 to $0.96 over a 1-week period. Though UST eventually returned to its peg, this event prompted concerns that its economic model was not viable long-term, particularly if the market cap of UST exceeded that of LUNA or if a sizable liquidation cascade occurred — potentially leading to a runaway crash.

In order to address concerns and provide a backstop for the UST price, a non-profit known as the Luna Foundation guard (LFG) accumulated $3.5 billion in reserves of various volatile assets (including BTC and AVAX). But these funds were insufficient to stop a cataclysmic series of liquidations, which in May 2022, sent the price of UST tumbling from $1 to as low as $0.044. Meanwhile, LUNA saw its value collapse from over $80 to just a tiny fraction of a cent while its circulating supply expanded exponentially.
This event also saw its arbitrage mechanism falter, as a daily capacity limit and gradually increasing slippage made it impossible to actually exchange 1 UST for $1 worth of LUNA. Not to mention the fact that there was typically a significant spread between the oracle price and the actual exchange value.
This event reverberated throughout the broader DeFi and stablecoin space, disrupting numerous Terra-based protocols, and even causing a collapse of USDX — Kava Labs-built stablecoin that was partially collateralized by UST. The stablecoin fell to its all-time lowest value of $0.45 and it is still trading significantly below its soft peg. Likewise, the algorithmic stablecoin Deus Finance’s DEI stablecoin has now been off-peg for more than a week.
In the later stages of UST’s collapse, allegations also emerged that Do Kwon was behind another previously failed algorithmic stablecoin known as Basis Cash, which collapsed into oblivion within weeks of launching.

It is now common consensus that the UST stablecoin is beyond the point of recovery, and will go down as one of the biggest missteps in cryptocurrency history — even drawing attention from US lawmakers due to its potential for economic damage. UST is now by far the largest failed stablecoin project and will serve as a blueprint for what not to do in future initiatives.

The Terra Saga: Post Analysis

Terra demonstrates the fragility of some blockchain-based economies and serves as a cautionary tale for developers looking to tackle the algorithmic stablecoin opportunity/problem as well as users who opt to use these coins over more traditional fiat-backed options.

Now, more than a week after its collapse, it is clear that Terra as it was once known is beyond the point of recovery, and what emerges from the rubble will be built on several compromises.

Despite initial reports that the Zurich-based investment firm GAM had organized a $3 billion rescue package for Terra, this was later proven to be fabricated.

“There is no truth in the story and GAM did not issue a press release. GAM has strict controls on the dissemination of press releases, and we are investigating the source of this story and how it came to be published,” said GAM in a recent press release.
Instead, the platform will need to complete a hard fork, essentially splitting a new blockchain away from the original Terra chain at a specific block, renaming the old [collapsed] chain as Terra Classic while the new chain will go on as the main chain (simply called Terra). This is similar to what happened to Ethereum in July 2016 after the infamous DAO Hack divided the Ethereum community and led to a fork that yielded two chains — Ethereum Classic (the original Ethereum) and Ethereum.

According to recent tweets, Terra founder Do Kwon and the majority of the network’s validators are confident that the new Terra 2.0 chain will be able to maintain the support of the ecosystem and broader development community, while providing a viable route for recovery.

It is currently unclear if the new chain will retain LUNA burn and mint function — which was used to power its UST stablecoin.

The new LUNA Go Forward Proposal is designed to incentivize developers and make as many members of the community whole as possible. It will include an airdrop of new LUNA tokens to Luna Classic stakers, Luna Classic holders, residual UST holders, and app developers. A large chunk of the new LUNA supplied will be reserved for developer alignment and mining programs.

The full token distribution is outlined as follows:

  • Community pool: 25%
    • Controlled by staked governance
    • 10% earmarked for developers
  • Pre-attack LUNA holders: 35%
    • All bonded / unbonded Luna, minus TFL at “Pre-attack” snapshot; staking derivatives included
    • For wallets with < 1M Luna: 1 year cliff, 2 year vesting thereafter
    • For wallets with > 1M Luna: 1 year cliff, 4 year vesting thereafter
  • Pre-attack aUST holders: 10%
    • 500K whale cap - covers up to 99.7% of all holders but only 26.72% of aUST
    • 15% unlocked at genesis; 85% vested over 2 years thereafter with 6 month cliff
  • Post-attack LUNA holders: 10%
    • Staking derivatives included
    • 15% unlocked at genesis; 85% vested over 2 years thereafter with 6 month cliff
  • Post-attack UST holders: 20%
    • 15% unlocked at genesis; 85% vested over 2 years thereafter with 6 month cliff

Despite the lack of transparency during the original LUNA/UST crash, it now appears that the Luna Foundation Guard burned the bulk of its reserves in an attempt to defend the UST peg. According to its latest update, the non-profit expended more than 80,000 BTC, 26 million USDT and 23.5 million USDC in its failed strategy to restore the peg. Its reserves now constitute just a small fraction of what they were a week ago.

On a more sombre note, there has now been more than a dozen suicides reportedly as a result of the Terra collapse, and hundreds of thousands of investors have been left devastated. Despite this, the original LUNA and UST cryptocurrencies can still be traded on a wide variety of exchange platforms, though most derivatives trading platforms have closed future contracts for these assets.

In the aftermath of the Terra crash, founder Do Kwon has been subject to more than a few legal threats, and the South Korean Tax Service slammed both him and Terraform Labs with a $78.4 million tax bill for allegedly evading tax. The news comes alongside reports that three members of the Terraform Labs legal staff left the company — possibly due to the legal mess the company is potentially embroiled in.

Things continue to go from bad to worse for Kwon, who despite having a sizable following on social media, is now regularly disparaged by industry figureheads and the broader LUNA community.

How Are Other Algorithmic Stablecoins Faring?

Though TerraUSD is by far the best-known algorithmically stabilized cryptocurrency, it’s actually part of a larger sector formed of a small assortment of ideologically similar projects. These projects all attempt to provide a stable unit of value, without resorting to fiat collateralization.

Though some believe that these solutions are inherently fragile and are just a catastrophe waiting to happen, a handful of algorithmic stablecoins have proven remarkably resilient.

One of the most prominent of these is NeutrinoUSD (USDN), a Waves-based stablecoin that is collateralized by WAVES tokens. Like UST, USDN has an adjustable supply that can be expanded or contracted based on demand. To mint USDN, users need to lock up WAVES tokens worth significantly more than the USDN they want to receive and must return their USDN to retrieve their collateralized WAVES.

In the last month, the token has deviated from its peg significantly on two occasions, dropping below 80 cents both times, before sharply recovering, demonstrating that its peg restoration mechanism is able to contend with significant deviations.

Other, arguably more daring algorithmic stablecoin ventures have fallen spectacularly flat. This includes a slew of so-called rebase tokens, which inflate or contract the supply based on positive or negative deviations from the peg to help stabilize its value. By far the best known of these is Ampleforth, which attempted to use a rebase mechanism to maintain the price of AMPL at the purchasing power of the 2019 USD.

Since its launch more than a year ago, the price of AMPL has been anything but stable and has touched as high as $4.04 and as low as $0.29 in this time. A variety of other rebase tokens with an elastic supply have also failed to pick up momentum or maintain their peg too.

Future of the Algorithmic Stablecoin Model

The recent fiasco surrounding TerraUSD has not only increased scrutiny on the stablecoin ecosystem but on the cryptocurrency landscape as a whole, prompting lawmakers to increase regulatory oversight of the industry. The ramifications of this could be significant.

This is a welcome development for those who believe that regulations will increase security and confidence in stablecoins, and hence benefit the overall cryptocurrency ecosystem. But others believe that this opens the floodgates for a regulatory crackdown, which could reduce competition and increase centralization in the space.

Whatever the case, as it currently stands, the algorithmic stablecoin niche still contains several potentially viable candidates, most of which have experienced at least one significant deviation from their peg. Because of this, the industry is still far from dead. There are even early signs that the now much-maligned Terra and its associated UST stablecoin are gearing up for a comeback.

But with TRON’s recently released so-called "risk-free" 30% APY interest-bearing stablecoin known as USDD now picking up steam, some believe that a repeat is on the horizon and that the writing is on the wall for all algorithmically stable cryptocurrencies — which may be non-viable no matter the configuration.
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