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Terra's Crypto Crash Was Unavoidable

The entire business is in jeopardy due to an unprecedented fall in algorithmic stablecoins.

A handful of small-time but very astute retail cryptocurrency investors forecast the crash of terra and luna at a Mexican restaurant in North London a few weeks ago. Several of them laughed at terra, or UST, a stablecoin whose price equivalency to the dollar is based on computers and game theory rather than cash or collateral, and at the idea that it would keep its peg in the long run.

They advised me that the project's "Ponzinomics" were simply too dangerous. Only one of the investors expressed optimism, and it was based on nihilism rather than faith in terra's stability: he predicted that UST's price would rise well above one dollar per unit at some point, and the coin's promoters would decide to keep it there and rebrand the stablecoin as a "inflation-resistant cryptocurrency dollar." Another shrugged, but admitted that everything was up in the air. "This tale has always followed the most funny chronology," he remarked.

You can bet that a lot of folks aren't in the mood to laugh today. UST has lost its dollar peg (it is currently trading for $0.58 on cryptocurrency platforms), while its sister asset luna has dropped from $82 last week to $0.02. A significant portion of the $60 billion invested in these cryptocurrencies was vaporized overnight, and more will follow as consumers hurry to sell their dwindling coins.

Meanwhile, the larger crypto market is in chaos this week, with bitcoin dropping to $27,000 after losing 8% of its value in 24 hours, and several other cryptocurrencies following suit. On Thursday, Tether, the world's largest stablecoin, fell below $1.

With terra, we're seeing the demise of a project based on the idea that you can generate money—and assign it a specific value—if people are willing to believe money has the worth that crypto businesses assign it, similar to role-playing in a video game.

A small group of ardent crypto believers would argue that in the post-gold-standard era, most currencies are nothing more than a collective hallucination. However, there is no government, central bank, economy, or actual usage to support terra issues. "It's comparable to a bank run, but it's a run on nothing," Frank Muci, a policy fellow at the London School of Economics' Growth Lab Research Collaboration, puts it.

UST was advertised to the general public as a stablecoin, a form of cryptocurrency whose value is expected to be constant over time, providing a useful hedge against the wild price volatility of other cryptocurrencies like bitcoin or ether. Most stablecoins rely on currency reserves (whoever produces a stablecoin tied to the dollar should potentially store an equivalent quantity of dollars in a vault somewhere) or other collateral, such as crypto. UST, on the other hand, is a "algorithmic stablecoin" with none of that. It is completely isolated from the outside world and proud of it.

UST has a symbiotic relationship with its satellite asset luna, which can be used to gain cryptocurrency rewards on Terra's own blockchain. It was always possible to exchange UST for luna and vice versa, and the blockchain's own logic ensured that terra always traded at a dollar per unit, but luna's price fluctuated according to market conditions.

This was designed to keep its price steady by using arbitragers' efforts to benefit from market inefficiencies. If a sell-off of UST on cryptocurrency exchanges threatened to drive its price below $1, clever arbitragers would rush to acquire UST and use them to buy luna at a discount on the local blockchain, so shoring up UST's price.

If the price of UST rose above $1 on crypto exchanges, consumers would use their lunas to purchase one-dollar-per-unit USTs on Terra's blockchain and resale them on other platforms, lowering the price of UST. It's an ingenious design. It's also one that hasn't and won't work. "It reminds me of perpetual motion machines." People were interested in learning how to obtain free energy. "They'd have pulleys, magnets, and levers," Muci said of the ideas. "It's a little bit the same notion with algorithmic stable currencies."

In a study devoted to algorithmic stablecoins titled "Built to Fail," Ryan Clements, an assistant professor of business law and regulation at the University of Calgary, laid out the problems with this method last year. According to Clements, one of the primary issues with stablecoins is that they can only work as long as there is demand for them; otherwise, all those incentives are useless. "UST was never completely collateralized and was never stable to begin with," Clements argues. "It necessitated a constant dependence on the idea that there would be adequate (ongoing) interest in the Terra ecosystem's different UST use cases."

Many cryptocurrency investors began to arrive at the door. One probable explanation for what occurred to UST, according to Bobby Ong, developer of cryptocurrency analytics platform CoinGecko, is a "George Soros-style" attack, referring to the Hungarian billionaire and financier's famous bet against the British pound in 1992. According to this idea, UST's disastrous decline—which began on Monday and culminated in a disaster on Wednesday—was prompted by a huge entity dumping billions of UST on the market, causing its peg to be shattered. Another, more straightforward explanation is that UST was just unsustainable, and this was bound to happen as soon as market sentiment shifted.

It's telling that certain crypto personalities are blaming investment management firm BlackRock and hedge fund Citadel for the alleged attack. Citadel had already been branded as the villain in another financial craze, the so-called GameStop debacle, when millions of retail investors began buying the struggling game shop chain's stock in droves, despite its doubtful fundamentals, in an unusual act of defiance against traditional finance. Several commentators hailed the rise of meme finance, in which asset values were determined by communal delusions, performative contrarianism, and simple nihilism rather than commercial potential ("Is [GameStop's stock] worth 200+ dollars? That's up to you to decide depending on your own set of values," one investor said on Reddit, where the revolt began.)

Terra's rise and fall are, in some ways, the culmination of that long period of strange finance. It is possible that it will not rebound and will instead follow in the footsteps of earlier Web3 downturns, such as the bursting of the NFT bubble or the collapse of a large number of meme stocks and dog coins.

But reading all of this through the lens of absurdism and pipe dreams would be deceptive. Terra's meteoric rise in popularity in the last six months has also been fueled by incredible incentive programs. "A savings system dubbed Anchor on Terra's blockchain, which offered a 20% annual percentage interest, drove the high demand for UST," explains Ong. People would buy UST and save it in Anchor, a piece of software that allowed them to store their coins and watch them grow over time like a magical money tree. What's more concerning, according to Ong, is that Terra set an example for a slew of other crypto enterprises that began promising outrageous profits but are now in grave danger of collapsing.

The Ponzinomics were too obvious: When you buy money for nothing and put it in a protocol with the hope of getting a 20% yield, all you get is 20% of nothing.


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