The not-so-stable coins: How Terra’s collapse is dragging down crypto markets – Grid News

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The not-so-stable coins: How Terra’s collapse is dragging down crypto markets

Cryptocurrency markets are on the downturn alongside the broader stock market. The value of the world’s largest and best-known cryptocurrency, bitcoin, slid from about $39,000 to around $28,000 over the last week — hitting a 52-week low and giving new fuel to questions about its ability to store value over the long term.


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But that’s not the biggest crypto crisis these days. The value of TerraUSD, abbreviated as UST, a so-called stablecoin whose value is pegged to the dollar, has collapsed this week and now hovers around 63 cents — potentially adding to the downward pressure on bitcoin and prompting new calls for regulation.

The slump comes as crypto — once marketed as an alternative to the traditional financial system — is increasingly embraced by institutional investors and traditional financial firms. Late last month, for example, Fidelity Investments said it would allow participants in its 401(k) retirement plans to incorporate bitcoin into their holdings. But unlike stocks, bonds and other longstanding investment instruments, cryptocurrencies are largely unregulated, and some observers see decentralized stablecoins as inherently risky.

“UST’s failure to maintain its peg was predictable,” said Ryan Clements, an assistant professor of Business Law and Regulation at the University of Calgary, who has written about the unpredictability of algorithmic stablecoins — a category that includes Terra. “Algorithmic stablecoins are based on confidence and trust in the economic incentives of the stablecoin issuer’s underlying ecosystem. Once that trust and investor demand evaporates, they quickly fail in a death spiral — and we saw that yesterday. ”

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The currency’s crash grabbed the attention of a top federal financial official, Treasury Secretary Janet Yellen. She told a Senate committee on Tuesday that “digital assets may present risks to the financial system.” She also called for regulations and said that stablecoin guidance could come as early as this year.

“A stablecoin known as TerraUSD experienced a run and declined in value,” Yellen said. “I think that this simply illustrates that this is a rapidly growing product and there are rapidly growing risks.”

What is an algorithmic stablecoin?

Stablecoins are meant to be a hedge against cryptocurrency volatility and are easier to move between decentralized exchanges. They are intended to stay at a certain value, offering a one-to-one swap between assets, which are generally pegged to the U.S. dollar. The available offerings include Tether (USDT), with over $83 billion in market cap and Circle (USDC) with $43 billion, among others.

In April, Terra briefly became the third-biggest stablecoin by market cap with about $18 billion. It’s a decentralized algorithmic stablecoin, which means it is not backed by centralized entities such as a bank or company and therefore not subject to the control those actors might exert. Many such currencies have entered the market, but so far, few have succeeded. Traditional stablecoins are generally backed by reserves to ensure they maintain that one-to-one peg. But algorithmic stablecoins work on trickier math; they’re based on algorithms and smart contracts that incentivize traders to maintain a steady price.

TerraUSD is mutually dependent on another coin — Luna. Every time a UST is minted, or created, a Luna is burned — removed from circulation. The same thing happens in reverse when a Luna is minted. This creates trading margins and supply and demand models that help keep the coin pegged to $1. If the price dips below $1, traders can burn their UST for $1 worth of Luna. This reduces the overall supply and results in the price being raised. Similarly, if the value of UST goes higher than $1, traders can burn Luna for UST, increasing the supply and lowering the price.

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Another key part of the Terra ecosystem is the interest rates on UST deposits offered through Anchor Protocol, a decentralized finance (DeFi) platform, which can garner annual percentage yield rates of 20 percent.

In theory, the system nudges traders to make quick profits by burning and minting coins. But as recent events have shown, it’s far from foolproof.

Over the last few days, the UST stablecoin has become erratic and lost its peg to the dollar, slipping to as low as 3 cents and erasing billions in market cap. Luna, which was valued at around $87 a week ago, has now fallen to $0.02.

Do Kwon, co-founder of Terraform Labs, which developed Terra, has tweeted that there is a rescue plan in place. “I understand the last 72 hours have been extremely tough on all of you — know that I am resolved to work with every one of you to weather this crisis, and we will build our way out of this.”

Terraform Labs did not respond to a request for comment.

UST is not the first algorithmic stablecoin to undergo a rapid slump. Last year, the Iron Finance Protocol, (which included $IRON and $TITAN tokens) collapsed, losing nearly $2 billion in value in a day in what the team later said was crypto’s first “large-scale bank run.”

“UST was never stable to begin with and was never fully collateralized,” said Clements. He argued that it depended on continued interest in Terra, “including unsustainable yields on the Anchor Protocol,” coupled with support from crypto reserves, sufficient trading fees to shore up those reserves and “enough willing arbitrageurs to constantly ensure a peg without ‘stepping back’ from the ecosystem.”

Kristin Smith, executive director of the Blockchain Association, said the stablecoin sector is a critical and complex part of the crypto ecosystem.

“Like all new technologies, these assets — including dollar-backed, crypto-collateralized and algorithmic models — present unique benefits and risks that deserve a smart and thoughtful conversation around potential regulation,” said Smith. “The Blockchain Association stands ready to serve as a resource to policymakers as they examine the events of this week and look to learn more about this evolving sector.”

What does this have to do with bitcoin?

Kwon and the Luna Foundation Guard (LFG), which backs Terra’s UST stablecoin, made headlines earlier this year when they announced plans to diversify their backing by purchasing $10 billion in bitcoin. But LFG liquidated its bitcoin holdings when Terra began to slide, flooding the market. Its treasury wallet was emptied of its 42,350 bitcoin on Monday. Some analysts think that, in turn, encouraged bitcoin’s slump. Bitcoin dropped to $26,350 on Thursday, its lowest price since December 2020.


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Travis Bott, the founder and CEO of Meta Labs Agency, a consulting firm, said that with USDC or USDT, you have the stablecoins that ultimately hold a reserve of dollars against the issued tokens to back them, as opposed to an algorithmic approach.

“At the end of the day, it’s not a reflection of all stablecoins, because they weren’t all built the same under the same philosophy. This one was very different,” said Bott. “Ultimately, I’ve been skeptical of Luna because when you see somebody launch something, and then immediately they start deviating from their base protocol and adding in things like buying $3.2 billion worth of bitcoin as a treasury to try and back their coin, you kind of scratch your head and say, ‘Why would they be doing that if the algorithm was sound?’”

In the wake of the Terra collapse, other signs of the crypto sector’s vulnerabilities have emerged. Coinbase, the U.S.’s most prominent cryptocurrency exchange that went public in April 2021, filed documents Tuesday with the Securities and Exchange Commission that warned in the event of bankruptcy, it could take users’ holdings with it. Coinbase CEO Brian Armstrong was clear that bankruptcy is not an imminent risk, however. Meanwhile, another algorithmic stablecoin, Neutrino, has started to slip from its peg, and on Thursday morning, Tether, the largest stablecoin by market cap, briefly lost its peg as well.

And as inflation rises bitcoin continues to slip, undercutting arguments that it can function as a store of value and hedge against things like inflation and a depressed stock market, given it has a finite supply that is supposed to increase it’s value only as real wages and purchasing power drop.

Terra’s future is unclear. The coin’s peg to Luna hasn’t been restored, and its market cap is more than $4 billion higher than Luna’s.

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“Will the peg be restored? How? When? Will there be an external capital infusion? The capitalization of Luna as collateral is lower than UST (so technically the project is insolvent). Will this be remedied? And how?” asked Clements in an email to Grid.

“These projects require a thoughtful regulatory framework as I’m sure there has been some tragic losses by unsuspecting retail investors in both coins that didn’t understand how fragile their so-called ‘stablecoin’ was to begin with,” he wrote.

Update: Since the publication of this article, Terraform Labs, the company behind the larger Terra ecosystem, announced it was halting the Terra blockchain, meaning that transactions with its its associated tokens cannot be processed. It was restarted soon after the tweet announcement.

Thanks to Lillian Barkley and Alicia Benjamin for copy editing this article.

  • Benjamin Powers
    Benjamin Powers

    Technology Reporter

    Benjamin Powers is a technology reporter for Grid where he explores the interconnection of technology and privacy within major stories.