Max pain: Terra’s seven day $30b to $3b collapse


Rather than writing yet another post about macro, interest rates and impending doom, I wanna focus on a different type of doom: The collapse of the Terra / Luna ecosystem, a little thing called algorithmic stablecoins and just how it all went bad.

Warning: This is not a light read. Some of the technical details are likely off. You should definitely spend your evening doing something else.

Terra is one of the darling blockchains which popped up during the great “holy cow Ethereum is expensive” migration of the past 2–3 years. Luna is Terra’s native token. As is the case with many of the L1 success stories, Terra is a blockchain which is capable of fast and affordable transactions at scale, has a solid ecosystem of dApps and developers, as well as a strong community centering around core developer Do Kwon.

For context, Terra is not the only “alt” L1 to be experiencing a rapid drop in market cap. Competitors Solana and Avalanche had their respective token prices / market caps cut by more than half as well, essentially bleeding as bad as the Netflix / Peloton / Docusigns of the world. Yet even under these circumstances, Terra is special. Terra went from $80 to $2 in less than a week.

So what happened?

One of the unique attributes of the Terra ecosystem is that it comes equipped with a native set of stablecoins, most prominently a dollar (UST) and a won (KRT) stablecoin. Unlike cash / debt backed stablecoins such as USDC, which can be issued in accordance with a balance sheet somewhere out in the real world, Terra’s stablecoins are not backed by any real assets.

Terra instead went with an algorithmic stablecoin design. These stablecoins are created by “burning” Luna, Terra’s native utility token. Burning refers to eliminating / destroying tokens. For example: When Alice wants to have 10 UST, Alice must burn the amount of Luna which corresponds to the value of 10 USD. When Alice later wants to redeem the 10 UST for Luna, the 10 UST are burned and Alice receives the amount of Luna which corresponds to the value of 10 USD in return. This means that as more UST is issued, Luna decreases in supply, which drives up its price.

This system works as long as there is demand for the stablecoin. In the case of Terra, demand was created by providing a 20% APY opportunity on minting UST and then depositing it in Anchor Protocol, Terra’s native money market. Demand for such high yield proved to be consistent, with Anchor reaching TVL heights of almost $17b earlier this month, right before the collapse.

But what happens when demand suddenly drops off? If a large portion of UST holders were to suddenly want to convert their UST to USD, they would essentially have two options: 1. Trade their UST for other cryptocurrencies on public venues, using trading pairs which are not terribly liquid or 2. Convert their UST to Luna and attempt to trade Luna for USDC / USDT or other pairs. The more natural choice would be 1, since it’s an easy trade across Binance / Huobi / Kucoin. Once liquidity runs dry and slippage runs high, 2.would become the natural choice.

Now remember, if UST is converted back to Luna, new Luna is minted and added to the supply. This means that as more and more UST is being converted, Luna’s supply is being inflated and the fair price for Luna tokens must naturally drop. In the event of a panic, if everyone was trying to convert from UST/Luna to USD, the price of Luna would drop even more rapidly due to there now being liquidity issues with Luna/other pairs, in addition to the inflating supply.

These factors combine to form an algorithmic stablecoin death spiral. It’s crypto’s version of a run on the bank, only that an immutable smart contract can’t be shut down. Crypto banks can’t just close their doors and tell customers to come back a week after market turbulence. Every last penny of assets can and will be withdrawn in the case of market wide panic.

So is this the end of algorithmic stablecoins? The honest answer is I don’t know. Programmable money knows no limits and the talent in DeFi runs deep. But for now Terra must serve as an important reminder of the risks we take.