LUNA’s Crash Landing: Algorithmic Stablecoin Experiment Ends In Tears

May 13, 2022
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TerraUSD, a US dollar stablecoin that runs on the Terra blockchain, appears to have met its maker after shedding 70 percent of its market cap in a single day.

TerraUSD, a US dollar stablecoin that runs on the Terra blockchain, appears to have met its maker after shedding 70 percent of its market cap in a single day.

On Wednesday (May 11), the price of TerraUSD hit a low of $0.23, in one of crypto’s most spectacular crashes to date.

Since the beginning of the week, TerraUSD had been struggling to hold its peg to the dollar amid increased volatility and heavy selling across the crypto markets.

As VIXIO has reported previously, it is not unusual for stablecoins to briefly lose their peg during systemic volatility, but the extent to which TerraUSD fell from its peg, and the speed with which it dropped, was unprecedented.

From a high of $0.997 on Monday (May 9), TerraUSD came close to hitting zero on Wednesday, as short interest piled into its free-floating collateral token, LUNA.

In theory, each LUNA token could always be exchanged for its equivalent value in TerraUSD, and each TerraUSD token could always be exchanged for its equivalent value in LUNA.

As of Thursday, TerraUSD had managed to claw its way back to $0.60, but LUNA skidded even closer to zero, hitting a low of $0.017 at the time of writing.

On Monday, and prior to this spectacular fall, LUNA and TerraUSD had a market capitalisation of $22bn and $18bn respectively, making TerraUSD the third largest stablecoin after Tether and USDC.

How did it fall from grace?

For those unfamiliar with TerraUSD’s relationship to LUNA, think of LUNA as the bank vault that holds the assets to support the value of TerraUSD.

Up until Monday, TerraUSD had mostly held its peg to the dollar thanks to arbitrage traders who stepped in whenever it dropped below $1.

If TerraUSD fell below $1, traders would exchange one TerraUSD token for $1 worth of LUNA tokens.

Apart from making a quick profit in the process, this arbitrage trade would reduce the supply of TerraUSD by “burning” individual tokens, thereby raising the price of the remaining TerraUSD tokens. This was one of the functions of the Terra-LUNA algorithm.

Conversely, when TerraUSD’s value rose above $1, traders could make a profit by burning LUNA tokens and creating new TerraUSD, therefore increasing the supply of the stablecoin and lowering its price back towards $1.

However, what the algorithm could not prevent, or fix, is a situation in which there is no collective willingness to support the value of either the TerraUSD or LUNA tokens.

This is what happened on Monday when holders of both TerraUSD and LUNA started to run for the exits at the same time, thereby diluting the value of both.

In traditional financial markets, this is known as a “death spiral”.

Not a good look for stablecoins

The news of TerraUSD’s collapse has already travelled much further than the average crypto mishap story.

Hashtags such as "Luna Crash", "Terra Luna" and "Do Kwon" — the name of Terra’s South Korean founder — have trended on Twitter all week.

And as of Thursday, even Janet Yellen, secretary of the US Treasury, felt moved to comment on TerraUSD’s demise.

In a speech to Congress, Yellen asked lawmakers to move swiftly on passing a legal framework for stablecoins before consumers are harmed.

“The current statutory and regulatory frameworks don’t provide consistent and comprehensive standards for the risks of stablecoins as a new type of payment product,” she said.

“The case of the Terra stablecoin illustrates that this is a rapidly growing product and there are risks to financial stability and we need a framework that’s appropriate.”

Yellen said she agrees that digital assets may present opportunities to promote innovation and increase efficiencies, but they also pose risks to the financial system.

She pressed for urgent “bipartisan” action to create such a framework, and told Senator Pat Toomey (R-PA) that her office “would look forward to working with you”.

The word bipartisan is particularly important in this remark, at a time when the US is led by a Democrat trifecta, and senior Republican Toomey is pressing for more crypto-friendly legislation.

For years, Toomey has been criticising the Securities Exchange Commission (SEC) for its alleged lack of clarity in the application of rules regarding crypto products, and has been calling for a framework that spurs rather than “stifles” innovation.

In April, Toomey released a discussion draft for payment stablecoins that would establish three regulatory paths for stablecoin issuers.

It would allow banks to issue stablecoins, while non-bank issuers could decide whether they register under state money transmitter regulations or apply for a new federal licence from the Office of the Comptroller of the Currency (OCC), which is also responsible for chartering national banks.

To protect consumers, Toomey’s Stablecoin TRUST would impose disclosure requirements on the issuers.

His proposal came in response to a November 2021 stablecoin report which recommended that stablecoin issuers be insured depository institutions.

The report was the result of coordinated work by the main federal financial regulators and the Treasury.

“I am grateful for your point and I hope you would agree to work with my colleagues,” Toomey said to Yellen before Congress.

Asked whether legislation could be “done” this year, Yellen said “it would be highly appropriate”.

“We really need a consistent regulatory framework. I really look forward to working with you and members of Congress to devise legislation that accomplishes that,” she said.

Another US regulator chimed in on stablecoins while moderating a panel on central bank digital currencies (CBDCs).

Nellie Liang, US undersecretary of the Treasury for domestic finance, said that stablecoins “could” be used for payments in the US, but that they come with old risks, including market failures.

“Stablecoins are bearer instruments issued by non-banks,” she said. “They have the potential to generate destabilising runs if the value of the assets backing the stablecoin decline abruptly.

“They may also introduce novel payment system risks related to distributed ledger technology.”

Stablecoins unfairly targeted

The high-profile collapse of TerraUSD appears to have reinforced the US Treasury’s distrust of stablecoins, and accelerated its move towards tougher regulations.

But to speak in terms of “destabilising runs” and “risks to financial stability” about all stablecoins is unfair, according to some experts and policymakers, especially given that TerraUSD was perhaps the most experimental stablecoin ever attempted in crypto.

By contrast, crypto’s two largest stablecoins by far, namely Tether and USDC, are backed one-to-one by dollars in bank accounts.

In the case of Tether, with its market cap of $82bn, this has been proven repeatedly, despite claims and lawsuits to the contrary.

Similarly, USDC, with its market cap of $49bn, is backed one-to-one by US dollars held by regulated US financial institutions.

Patrick McHenry, Republican Congressman for North Carolina, said as much to Yellen during a House Financial Services Committee hearing on May 12.

“This week we’ve seen dramatic volatility within a particular algorithmic stablecoin,” said McHenry.

“I want to be clear: not all stablecoins and not all digital assets are the same, nor should they be regulated the same.

“It’s time for Congress to act to give these markets the stability they deserve. New technologies deserve time to be understood before being labelled a risk.”

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