TerraUSD Crash Won’t End Dreams of an Algorithmic Stablecoin

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TerraUSD Crash Won't End Dreams of an Algorithmic Stablecoin

Bloomberg Opinion — All those who are attentive to the crypto world have their eyes on terraUSD (UST)the algorithmic stablecoin that is part of the Terra blockchain ecosystem and is supposed to maintain a 1:1 parity with the US dollar.

Over the past week, it hasn’t maintained that peg and the value of UST has plummeted from $19 billion to $1 billion. Luna, the native token for the Terra blockchain (similar to how ETH is the native token for Ethereum), has tanked from a peak market cap of over $40 billion.

In light of this high-profile loss, American University professor Hilary Allen told Bloomberg that he “would not be surprised if this was the end of algorithmic stablecoins.”

Shared by many commentators, this perception is probably wrong.

Uncollateralized algorithmic stablecoins are a way of creating a faith-based cryptocurrency without the backing of strong collateral, creating something out of thin air, like the US dollar.says Jon Wu, head of growth at crypto privacy startup Aztec Network. “And there will always be people chasing that vision”.

As Wu detailed in a viral Twitter thread, a key reason people wanted to hold UST was that Terra offered an annual percentage rate of about 20% on tokens invested in the ecosystem’s Anchor protocol. The interest was paid from the Terra ecosystem’s multimillion-dollar fund, made up mostly of luna tokens (Matt Levine calls the roughly 20% APR a form of “promotional interest” to attract demand).

To understand why such projects will continue to crop up, let’s discuss the purpose of a stablecoin as highlighted in a Terra deep dive by Joe Weisenthal and Tracy Alloway:

  • Maintain a constant value: Crypto markets are “volatile and fragmented”, creating uncertainty for market participants. Stablecoins are “a way to move money with the confidence that you won’t lose a large sum” of your crypto holdings.
  • Important for decentralized finance: The constant value created by stablecoins makes them an important building block for decentralized finance, “enabling investors to transact in cryptocurrencies and digital assets. They are used in a wide variety of credit, loan, trade, and yield crop programs.”

Which brings us to the next question: How do stablecoins provide constant value? According to the Gemini exchange, there are four main ways to do this:

  • Fiat-Backed: A stablecoin backed at 1-to-1 parity with a fiat currency that is held “in reserve with a central issuer or financial institution” (for example, USDT from tether).
  • Commodity-backed: A stablecoin backed by “physical assets such as precious metals, oil, and real estate” (eg, tether gold, XAUT).
  • Cryptocurrency-backed: A stablecoin that is backed by a cryptocurrency collateral, such as ETH, and is managed by “smart contracts rather than relying on a central issuer” (e.g. MakerDAO).
  • Algorithmic: These stablecoins are not backed by fiat, crypto, or physical assets. Rather, they create price stability based on “specialized algorithms and smart contracts that manage the supply of tokens in circulation” (for example, Terra’s UST).

However, there are pros and cons with each stablecoin.

Fiat-backed and commodity-backed stablecoins are not native to the crypto ecosystem (“off-blockchain”), while crypto-backed stablecoins are “on the blockchain”but they require a higher collateral because crypto assets are very volatile.

In algorithmic stablecoins, token supply management, in the case of terra, the exchange between UST and luna tokens, creates the possibility of a death spiral when dollar parity is broken. The Terra team even bought over $3 billion worth of bitcoin in an attempt to provide concrete guarantees separate from their algorithm and collective faith in the protocol.. And this reserve was depleted in an attempt to defend parity.

Despite this flaw, the crypto industry keeps returning to the algorithmic playbook. Before terraUSD, there was safecoin, nubits, IRON, and basis cash (Terra co-founder Do Kwon was also behind this project).

Going forward, fiat-backed stablecoins should remain the biggest players in the game: Tether’s USDT and Circle’s USDC are worth about $130 billion combined. Nevertheless, an unsecured algorithmic stablecoin remains the “holy grail” for the crypto industry according to Wu of Aztec Network.

“Look at MakerDAO,” Wu explained to me over the phone. “To mint $1 of your [token] DAI, you need approximately US$2 of collateral. It is not very capital efficient. By comparison, algorithmic stablecoins allow you to create something out of nothing. There will be another founder claiming to have discovered a new algorithmic solution and there will always be an investor willing to fund the idea, even if most industry insiders are aware of the risks if it fails.”

To prepare for the next algorithmic stablecoin, Wu says the industry needs to establish internal disclosure standards for retail investors.

Over the past weekend, billionaire Mark Cuban, who lost an investment in Iron Finance’s titan algorithmic stablecoin, shared a similar insight:

Where I think regulation is absolutely necessary is with stablecoins. Only tokens pegged to a cryptocurrency with equivalent assets should be able to call themselves a stablecoin. Algorithmically defined tokens should be called anything but a stablecoin.

Whatever name the industry ends up giving to “algorithmic stablecoins”, expect to see more of these projects in the future.

This note does not necessarily reflect the opinion of the editorial board or of Bloomberg LP and its owners.

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