The Truth About Stablecoins
This last week, we saw the spectacular implosion of a thoroughly vetted, allegedly transparent, public consensus protocol … but enough about the Philippine Elections, let’s talk about TerraUSD and $LUNA! 🤣🤣🤣 Jokes aside, you’ve probably been watching the crypto market meltdown this week and wondering if it’s time to call it quits. Is crypto done for? Hell no! Weeks like these come along at least once every 2-3 years, and they shake out all the investors that were initially attracted to crypto’s fast-moving gains, but couldn’t stomach its equally fast-moving losses. We’ve been through this before. In January 2015, $BTC went from $289 to $175 overnight. In November 2018, it was $5500 to $3800. May 2021: $46K to $34K. You get the idea. You’re probably thinking, “yeah, but $BTC didn’t go to zero like $LUNA just did,” which brings me to the topic of this Saturday’s letter. What exactly happened with the whole $LUNA and $UST (TerraUSD) crash?
In order to understand how all this works, let’s talk about the granddaddy of all stablecoins, $USDT, which is owned and issued by the Tether Foundation. $USDT was created in 2014 as a way to trade dollars without actually moving any dollars, allowing OG exchanges like Bitfinex to grow rapidly without having to worry so much about banking and regulations. In order to get a freshly-minted $USDT, you had to deposit real dollars with the Tether Foundation. That $USDT could be used in place of a normal dollar in practically any crypto exchange, and when you wanted to cash out and get your real dollars back, you would go back to the Foundation to do so. The most important part of the whole idea was that every USDT was actually backed by a normal USD.
Over the years, there’s been some controversy around what the Tether Foundation actually does with the USD deposits, and in 2018, a more “transparent” stablecoin was introduced by Circle.com called USDC. Functionally, USDT and USDC are exactly the same, they both simulate the US dollar at a 1:1 rate. Their method for achieving this parity is exactly the same too. Both systems require people to deposit their real dollars in order to receive the digital versions. The only difference is that USDC is deemed more “safe” for consumers because it regularly reports where and how all the deposits have been stored. The marketcap for USDT and USDC are $78B and $50B respectively, and yes, that does imply that they are sitting on a total of nearly $130B in customer deposits.
Of course, if you’re a pure crypto nerd, you don’t like these centralized solutions because it implies that Tether or Circle could cut you off if they don’t like you. (For example, if you were living in Russia, a US company like Circle could refuse to honor your USDC.) The decentralized solution was a new category called “algorithmic stablecoins.” The most successful early example was $DAI, which was issued by the Maker Foundation in late 2017. Instead of being backed by real dollars in a bank somewhere, $DAI is backed by $ETH. Of course, you can’t just have a volatile asset backing a stable one because you’d never be able to maintain the price parity, so what Maker proposed was to overcollateralize their stablecoin. In simple terms, you needed to deposit $150 worth of ETH in order to get $100 worth of DAI tokens. Why would people do this? Because you could earn interest from the deposited $ETH (something which the original stablecoins couldn’t do), and since it was all smart-contract-based you could get your ETH back without a central authority blocking you. Even Maker themselves couldn’t stop you from interacting with the system. (More information on how DAI works here.)
This brings us finally to the star of the show. In 2018, TerraForm Labs debuted a novel approach to the algorithmic stablecoin challenge. Like $DAI, $UST’s price was stabilized by trading a volatile asset, but in this case, the volatile asset wasn’t $ETH, but a totally new token called $LUNA. The idea was that you could keep the value of $UST at exactly $1.00 by constantly buying, selling, issuing, or burning $LUNA. This was done algorithmically, and it was a wildly experimental concept. Here’s how it worked: Whenever the demand for $UST increases, $LUNA supply is reduced through burning, and when demand for $UST decreases, fresh new $LUNA tokens are issued. The market prices of the two assets would theoretically respond to the change in supply, and if you did this quickly enough, you could always keep the $UST rate pegged to $1.00. ($LUNA’s price, meanwhile, would be allowed to float.) This approach became popular quickly because higher $UST usage implied a higher $LUNA price, so speculators could bet on $LUNA and ride its favorable price gains. And of course, $UST itself had a generous 20% annual interest rate if people wanted to just treat it as a savings account. (More details on the Terra algo here.)
At its height, $LUNA had a marketcap of over $40B, more than twice the marketcap of $UST at $18B. To most people, this meant that there was over 200% in crypto collateral supporting the stablecoin, and that sounded even safer than $DAI. The problem of course is that a marketcap is only a theoretical number: it’s the implied value of a token if you could convert them all into dollars at that exact moment in time. In reality, this is impossible. If you started selling large amounts of ANY crypto, the price would drop at an unpredictable pace. So although your first 10,000 LUNA could probably be sold at $100 each, your next 10,000 would probably have moved the market so much that you’d only be able to get $95. Your next batch would be even lower, and the fourth batch would be even lower still. Eventually, you’ll get to the point where you can’t find any more buyers, no matter how low your offer is.
This situation is roughly where $LUNA found itself this week. Some members of the #LUNAtics community are alleging that there was a coordinated attack, but to an outsider like me, it seemed equally likely that the market was just shit. Whatever the reason was, the Terra algorithm could not withstand the large-scale withdrawals from $UST that began on May 8th. $UST began to drift away from $1.00 a few cents at a time, and in response, the algorithm started issuing more $LUNA to attempt to maintain the expected equilibrium. The effect was like Economics 101: the oversupply of $LUNA caused the price to drop from $70 to $60. Now, this was still well within the parameters of how the Terra algo was supposed to work, but it looks like they underestimated how quickly markets would begin to panic during a bear market. With $LUNA’s marketcap now a bit smaller than it used to be (by May 10th, it was below $20B), $UST depositors became even more fearful for their funds. The volume of withdrawals increased even further, triggering the algorithm to create even more $LUNA. The death spiral had begun, and no amount of cheerleading from founder Do Kwon was going to save them. By May 11th, $LUNA had dropped to $30, and by Friday the 13th it was at $0.10. At the time of writing, it’s at a fraction of a penny, and big exchanges like Binance have halted all trading. The community is currently deciding how to salvage what’s left of their platform.
What lessons can we learn from the Terra debacle? For a lot of newcomers, the $UST concept was probably sold as “a great way to grow your dollar deposits by 20% per annum,” without actually being fully informed about how Terra is actually maintained. Stablecoins are generally a safe (if unexciting) place to store your wealth, but $UST was an extremely experimental approach that few people really understood. If you’re one of the folks who lost money on the $UST/$LUNA crash, my heart goes out to you. But this is a single facet of the crypto universe, and you shouldn’t take these losses as a signal that the rest of the market is doomed. I should also mention that $LUNA was not a rug pull or a scam, it was a genuinely innovative project that didn’t work out. Unfortunately, not all experiments end in success.
Tonight May 14th at 6pm, Celeste Rodriguez and I will finally be kicking off our crypto show at the YGGPilipinas social media pages. We’re calling it “CryptoCurious” and we’ll be answering your questions about what’s going on in the crypto world this week and share some pointers on how to deal with crypto winter. Come and hang out with us at fb.com/yggpilipinas at 6pm sharp!