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After TerraUSD’s crash, investors are re thinking algorithmic stablecoins. Mark Cuban had already warned about their risks

April 19, 2022, 4:15 PM UTC

The algorithmic stablecoin TerraUSD (UST) was once the third largest stablecoin by market capitalization behind USD Coin (USDC) and Tether (USDT). It was also once among the largest cryptocurrencies overall by market cap before its collapse.

The stablecoin, which was meant to always be worth a dollar, plunged to about 30 cents this week.

TerraUSD (UST)

While stablecoins have been gaining investors over the last year, a new type of stablecoin, the algorithmic stablecoin, had seemed poised to take over in popularity until TerraUSD’s crash.

TerraUSD was created by South Korean crypto developer Do Kwon and his company, Terraform Labs. The goal is to maintain the coin’s dollar value through a system that relies on traders burning or creating tokens for profit to maintain a stable price. This process works through TerraUSD’s mutually dependent pairing with another Terraform Labs cryptocurrency, Luna. Every time a TerraUSD token is minted, the equivalent of $1 in Luna is burned, and vice versa. 

When the price of TerraUSD drops below $1, traders can burn TerraUSD, or remove it from circulation, in exchange for a dollar in Luna. This reduces the supply of TerraUSD tokens, and therefore raises the price of the token. If the price of TerraUSD exceeds a dollar, traders are incentivized to burn Luna in exchange for a dollar in TerraUSD, which increases its supply and drops the price.

This algorithmic balancing act is intended to maintain the price of TerraUSD at $1, and had been mostly successful—until it lost its dollar peg on Saturday and dropped to 30 cents later in the week amid a broad selloff.

Since it was created in 2020, TerraUSD’s price had only dropped far below a dollar twice, according to CoinMarketCap. In December 2020, it tumbled to around 85 cents and to about 94 cents in May 2021.

Some have criticized the approach that TerraUSD’s creators have taken and those of other rival algorithmic stablecoins, such as Frax and FEI USD. Well-known investor Mark Cuban said he lost money when the algorithmic stablecoin IRON lost its dollar peg after a selloff by large investors. He has said stablecoins will be the first to be regulated by the federal government, which is considering new rules for the crypto space. 

“What is an algorithmic stablecoin? Is it stable? Do buyers understand what the risks are? It needs standards,” Cuban tweeted in September

Controversy around algorithmic stablecoins

Algorithmic stablecoins had been gaining in popularity, but now investors are hesitating.  

In the last quarter of 2021, TerraUSD saw a 260% increase in its overall market value, according to CoinGecko. About 17.5 billion TerraUSD tokens were in circulation as of April 19, but as of May 12, the number was down to 11.78 billion. 

Ryan Clements, a University of Calgary professor, wrote in the Wake Forest University Law Review in October that algorithmic stablecoins only maintain their price because traders expect the coin to have value in the future. If traders lose faith, they could cause a stablecoin’s value to collapse.

“These uncollateralized digital assets, which attempt to peg the price of a reference asset using financial engineering, algorithms, and market incentives, are not stable at all but exist in a state of perpetual vulnerability,” he wrote at the time. 

The problem with algorithmic stablecoins is three-fold, according to Clements. First, the supposedly stable cryptocurrencies require a certain level of demand to operate as expected. If demand falls below a certain threshold, the system falls apart.

Second,  the stablecoins are fragile because they rely on independent, self-interested investors who have to have an interest in making money from the algorithm meant to keep TerraUSD pegged to a dollar.  

Finally, Clements writes that in times of crisis this type of stablecoin could be prone to losing value based on traders acting on unclear information and uncertainty. In the end, it could cause herd mentality that could cause a broad selloff and cause the price to fall. 

Ultimately, algorithmic stablecoins could be prone to “bank runs” if traders keeping the price afloat decide to take their money out of the system over a short period of time, Clements argues.

He writes in the report that algorithmic stablecoins should be regulated to guard against what he calls “a system that will be prone to runs, destabilization, and failure when reality deviates from the assumptions underlying the embedded incentive structure.”

Do Kwon makes a big bet on algorithmic stablecoins

Terraform Labs’ Do Kwon is undeterred by critics. A pseudonymous crypto investor who goes by the name Gigantic Rebirth, or GCR, bet Kwon $10 million in March that in a year’s time his Luna cryptocurrency would be worth less than $88. After Luna started collapsing, Gigantic Rebirth doubled the $10 million bet and Kwon accepted.  Earlier this year, Kwon announced plans to obtain $10 billion in Bitcoin to hold as reserves to back TerraUSD. In early April, he told tech news site TechCrunch that Terra had purchased a total of $1.6 billion worth of Bitcoin so far, and that it planned to purchase another $1.4 billion through the Luna Foundation Guard, a nonprofit organization that supports TerraUSD and Luna. The Terra Protocol, which underpins both TerraUSD and Luna, will obtain the next $7 billion in Bitcoin from users who want TerraUSD and are willing to exchange their Bitcoin for the stablecoin.

Update, May 12, 2022: This article has been updated with a mention of TerraUSD’s (UST) drop below $1 and other recent stablecoin-related news.

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