TerraUSD’s collapse will take down every other algorithmic stablecoin, crypto analysts say

May 19, 2022, 8:19 PM UTC

From the beginning, Terraform Labs’ stablecoin UST was doomed to fail.

At least that’s what analysts say following UST’s spectacular collapse last week after having an $18 billion market capitalization not long ago. The TerraUSD (UST) stablecoin was supposed to always be worth $1, but it had fallen to just nine cents as of Thursday, according to CoinMarketCap.

Because of how UST was structured, a “death spiral” was inevitable, said Columbia Business School professor Omid Malekan. Other algorithmic stablecoins will meet the same fate, he said.

“If I had to guess, I don’t think anyone serious is going to try this model anymore,” Malekan said.

UST’s problem was tackling the goal of being tied to the U.S. dollar as an engineering challenge. Unlike other stablecoins like Tether and USD Coin (USDC) that hold cash and less risky assets to back them, UST relied on an algorithm and a sister cryptocurrency, Luna, to keep its price from fluctuating. For every UST token minted, the equivalent of $1 in Luna was destroyed—and vice versa. Whenever the price of UST dropped below $1, traders were encouraged to burn UST for Luna, which would decrease the supply of UST and theoretically push its price up to equilibrium. Whenever UST was valued at more than $1, traders could take advantage of the price difference to mint UST and burn Luna, which would increase the supply of UST and push the price back down to $1. 

Other projects, like Basis and Basis Cash, have attempted mechanisms similar to UST’s before, but all were unsuccessful, Malekan said.

“What stands out about UST is how it got so much bigger and lasted longer than any of the prior attempts but still met the same fate, a total collapse,” he said.

The algorithm backing UST worked for a long time, but that was when crypto markets were mostly up and investor confidence was high, said Diogo Mónica, cofounder and president of Anchorage Digital, a U.S-based digital asset bank. But in a bear market the mechanism behind UST failed. Once UST lost its dollar peg, a vicious cycle took hold. People rushed to redeem their UST for cash, which increased the supply and dropped the price, leading to more redemptions. Ultimately, it resulted in a crash of both UST and its sister cryptocurrency, Luna, which lost 97% of its value in about 24 hours.

“Once you lose trust in the ability of this dollar peg token to maintain its stability everybody rushes to the exit,” Mónica said.

Yet, the problems that plagued UST are unique to the category of algorithmic stablecoins, which differ from other stablecoin categories that have mostly worked so far, Mónica said.

Fiat stablecoins like Tether and USDC claim to have non-crypto assets that equate to the value of all outstanding tokens. Accounting firm Grant Thornton reviews USDC’s holdings monthly to make sure that’s the case, and Tether’s reserves are also reviewed by independent accountants. 

Meanwhile, over-collateralized stablecoins like DAI, run by a decentralized autonomous organization called MakerDAO, are backed by other cryptocurrencies. DAI, which is tied to the U.S. dollar, is backed by crypto like Ether and others that are worth about 150% of the number of DAI tokens in circulation. The catch is that investors only get back part of what they invest in DAI tokens. For example, an investor who puts in $150 worth of Ether would get $100 in DAI back. The other $50 is locked by an algorithm and is liquidated only if the value of the cryptocurrency put in originally drops. This ensures that DAI always has enough money for investors who want to cash out.

The downside to fiat-backed stablecoins, for some, is that the assets that back them exist outside of the blockchain, which means they could be frozen or seized. For over-collateralized stablecoins, it’s that they require too big a loss in investment.

What UST was trying to be—a coin with a 1:1 peg to the dollar, but that also lacks non-crypto assets as backing—is something that the crypto community has tried to build for a long time, Mónica said. 

“It’s the Holy Grail of crypto,” he said.

After seeing UST collapse, Bette Chen, the cofounder of Acala, which created the stablecoin aUSD on a blockchain called Polkadot, said she’s more confident in the overcollateralized mechanism her team uses for its stablecoin. 

She added that UST’s crash comes with a silver lining in that crypto developers have learned a lot from it. She said her team is looking at how to fix the inefficiency of over-collateralization, or investors putting more money in than they get out. But as crypto shifts into what analysts say could be a long bear market, she said the stablecoins that survive will be the ones created with a focus on security rather than risk.

“In an up market, you can do a number of things to make yourself really grow, but in a downturn, that’s where you’ve got to survive,” Chen said.

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