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

The Rise of Algorithmically Stable Cryptocurrencies

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.

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.

The Case of TerraUSD

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.

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.

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 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.

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.

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.

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.