Digital Nugget: The end of the algorithmic stablecoin?

The Terra USD (ticker: UST) stablecoin losing its peg to the dollar likely marks the end of algorithmic stablecoins, or at least it will prevent them from reaching any meaningful market capitalisation.

In this Digital Nugget, we look at three main questions:

• Is the algorithmic stablecoin concept flawed?
• Was the Terra stablecoin collapse avoidable?
• What implications does this have for stablecoins and the crypto market overall?

Figure 1: TerraUSD price, source: Coinmarketcap

Why were algorithmic stablecoins so popular?

The crypto industry is based on the ethos of decentralisation; and the leading stablecoins being issued by centralised entities has led to a search for decentralised alternatives. This was further motivated by concerns about the veracity, sufficiency and exact nature of the leading stablecoin Tether’s reserves.

The leading decentralised stablecoin DAI, which is collateralised by crypto assets, ran into problems during the March 2020 flash crash as collateral prices collapsed. DAI has been innovating continuously to mitigate the platform’s weaknesses; however, it has never managed to capture more than 5 percent of the stablecoin market. In addition, one of the solutions to the March 2020 problems was to allow centralised stablecoins to be used as collateral for DAI, which has resulted in stablecoin collateralised DAI amounting to 60 to 70 percent of all DAI for part of 2021 and to date in 2022. This recycling of centralised stablecoins defied the goal of the industry’s search for crypto-native decentralised alternatives, and it left the market eager to embrace other credible alternatives.

Algorithmic stablecoins seemed to satisfy this need and they were one of the great success stories of 2021. Earlier this year, Terra USD (ticker: UST) became the third largest stablecoin behind market leader Tether and Circle’s USD Coin. UST’s market capitalisation grew more than 50-fold in 2021, and it doubled again in 2022 prior to the May 2022 crash.

Although several attempts at creating algorithmic stablecoins failed in the past, and therefore the risks were generally understood, the advantages of algorithmic stablecoins were also recognised, and the crypto market was ready to embrace them.

Despite UST’s eventual failure and many current claims of “I told you so”, Terra did a good job of navigating the challenges of creating and defending an algorithmic stablecoin and growing it to a meaningful capitalisation. They also appeared to be aware of many of the threats and vulnerabilities, and they were working to pre-empt them.

What Terra did not do wrong

We disagree with claims of UST having been a Ponzi scheme, or that having a stablecoin that is not backed by reserves was a fundamentally unworkable concept.

While relying on the algorithm alone would not be sufficient to ensure stability, relying primarily on the algorithm is somewhat similar to the risks of trusting deposits to commercial banks. No commercial bank would survive a run on the bank unless they are supported by their peers or the central bank. The deposits are loaned out long term and mostly unavailable to pay out depositors, should they demand this at the same time in large numbers.

Runs on banks rarely occur because in a “business-as-usual” mode, it does not serve depositors’ interests to attack the bank, there is implied support from the industry and the central bank, and deposits up to a certain amount are covered by various deposit insurance schemes.

If the same can be replicated in crypto (as a system that is in balance in a “business-as-usual” mode, has the resources or backing to protect it against rare instances of extreme stress, and is backed by some sort of insurance scheme), it could work just as well as commercial banking does. This is what Terra attempted.

We also disagree with the criticisms of the inflationary incentives that Terra used to grow adoption (by offering very high deposit rates on UST deposits in the Terra native Anchor lending protocol). It is common business practice to invest in incentivising early adopters to grow a business quickly, especially businesses that require scale to function. Reducing incentives and transitioning to operating without them once sufficient adoption has taken place is usually tricky; but it is achievable, as long as the product has gained enough acceptance and demonstrated its value to the market beyond the incentives.

What Terra did right

Terra built a system that functioned very well under normal conditions and were creating a broad ecosystem with multiple potential use cases for UST. The value of the growing ecosystem on top of the Terra chain added to the value of the Terra (LUNA) token, providing greater support for and confidence in the stablecoin.

Terra were also thinking ahead to pre-empt potential problems and responded quickly to issues that arose. They sought to forge an industry alliance, both informally, and formally, through the Luna Foundation Guard, which also included the president of the market making firm Jump Crypto. They raised funds and continued to build reserves to be able to intervene in case of extraordinary market imbalances in the UST stablecoin (due to either attacks or large one-off redemptions occurring, for example, as a response to scaling back incentives).

Had the algorithmic stablecoin concept carried on, such reserves, including their minimum and optimal size, could have been somewhat similar to the capital adequacy ratios of banks.

Terra also attempted to improve the liquidity and the user base for UST by readying a new market making pool on the Curve decentralised exchange. The moment when large amounts of UST were transferred out of the old trading pool made it easier to attack the stablecoin. Once fully established, the new trading pool would have made an attack on UST much more costly.

What Terra did wrong

Not incorporating the safety reserves in the concept from the outset was a flaw – it was too little too late.

There is also a fine line between a founder projecting confidence to inspire trust versus potentially alienating industry allies.

It is also a question how UST would have held up if Terra’s LUNA token (used for anchoring the value of UST) came under significant pressure for reasons that had nothing to do with the UST stablecoin. A situation where LUNA’s market cap could fall below UST’s market cap as the first domino to fall may not have been thought through – although this was not what brought Terra down.

It was ultimately a large, sustained and well-timed attack that crashed the UST stablecoin and Terra’s LUNA token. Although this may have been motivated by profit or competitive considerations, due to its scale, it may be more likely that it was motivated by genuine concern about the systemic risk that an algorithmic stablecoin would pose to the crypto market once it reached significant scale and market share.

And beyond the crypto industry, Terra possibly did not appreciate central banks’ concerns about the risks in algorithmic stablecoins – although the regulators have been very open and vocal about this. As central banks are considering launching central bank digital currencies (CBDCs) and creating a system where they coexist with stablecoins, they will care a great deal about control over their stability and will not entertain concepts that they do not trust.

Ultimately, the entire idea of stablecoins is to anchor a crypto asset to a fiat asset (most commonly to the dollar). When playing on the Federal Reserves’ turf, it is not wise to ignore their wishes and opinions.

Summary

There appears to be strong resistance to the algorithmic stablecoin concept, both inside and outside the crypto industry. Additionally, after the failure of UST, trust in the concept has been destroyed. Therefore, it is unlikely that algorithmic stablecoins will achieve anything but a small market capitalisation for the foreseeable future.

However, stablecoins with mechanisms that the market trusts (such as verified reserves) should benefit.

As the total value locked in decentralised finance (DeFi) protocols halved in the wake of the UST crisis, DeFi yields may increase to attract suppliers of liquidity.

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