Crypto’s audacious algorithmic stablecoin experiment crumbles

Algorithmic stablecoins, like their more ‘traditional’ counterparts, are supposed to provide calm in the chaos of crypto.
Image: Bloomberg

Algorithmic stablecoins, like their more “traditional” counterparts, are supposed to provide calm in the chaos of crypto. Instead, as investors in one such token are rapidly finding out, they can serve as lightning rods for volatility.

Rather than trading at $1, as designed, the TerraUSD coin, or UST, slipped over the weekend to around 99 cents. By Monday evening in New York, it had plunged to 60 cents, obliterating its previous low of 92 cents in May 2021. It clawed back some of its losses as the evening wore on to hover at around 78 cents — still solidly below its dollar peg, though, and a sign of trouble.

What caused Terra’s coin to become untethered is a topic of intense internet debate. The disconnect happened alongside a sharp selloff in cryptoassets — including a plunge in Bitcoin to below $30 000 — and a broader retreat from risk assets including stocks. Whatever the catalyst, it’s no small thing: There are around 18.5 billion of UST in circulation, according to CoinMarketCap, a big enough presence that its swings could have systemic implications for other coins and protocols. And Do Kwon, the crypto upstart behind UST, has previously committed to buying as much as $10 billion worth of Bitcoin as part of his support of the coin, further entwining the project with the core of the digital-asset market.

“It’s fairly clear that there is a crisis of confidence,” said Kyle Samani of Multicoin Capital. He added that it was not certain whether UST would survive. That raises the prospect of the current turbulence snowballing into one of the biggest crypto blowups in recent memory.

Issuers of conventional stablecoins like Tether’s USDT or Circle’s USDC maintain that their tokens are backed by “real” assets like cash or highly rated bonds on a 1-to-1 basis. These coins hold their peg because, the theory goes, they can be readily exchanged for cash or highly liquid cash equivalents. By contrast, algorithmic stablecoins attempt to hold their value through a combination of instructions encoded in software programs and active treasury management. UST — which functions in tandem with a related token, Luna — is the most popular and controversial of these kinds of tokens.

Terra’s mechanics

In the case of Terra’s stablecoin, if its price falls below $1, traders are incentivized to swap units of UST for Luna, which removes the former from circulation. Similarly, software programs are triggered to do the same. If the price rallies above $1, the mechanism applies in reverse – remove Luna tokens from circulation to create equivalent, new units of UST.

Traders seeking to profit from arbitrage opportunities regularly swap UST for Luna and vice versa, thus ensuring the price stays at or very close to $1. Another contributor to UST’s price stability was crypto’s equivalent of above-market interest rates offered through Anchor Protocol, a “decentralised lender” built on Terra’s blockchain. Anchor offers rates of around 20% on deposits of UST, which offered a significant demand incentive for the token.

But over the weekend, all of those mechanisms stopped working and UST lost its dollar peg, while Luna also slid in value. That led to a series of crypto market interventions from Kwon and the so-called council of the Luna Foundation Guard (LFG), a consortium of crypto players that includes Kanav Kariya of Jump Crypto. Jump Crypto declined to comment. Near midnight New York time on Monday, UST remained under pressure. Luna was trading around $29, down 52% from a day earlier, according to CoinMarketCap.

LFG is a nonprofit incorporated last December, according to a business profile from Singapore’s Accounting and Corporate Regulatory Authority. Kwon is listed as a director. Kwon, who splits his time between Seoul and Singapore, did not immediately return a request for comment.

“The biggest losers from all of this will be retail [investors] that didn’t understand the risks they were taking,” Multicoin’s Samani said.

© 2022 Bloomberg

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