The last 6 weeks have certainly been a painful experience for cryptocurrency enthusiasts and investors, with Bitcoin crashing a full 35% since May 15th (and, at the time of writing, a staggering 71% from its all-time high from mid-November 2021). Given Bitcoin’s dominance in the crypto market, wherein it accounts for roughly 42% of the entire volume of the global cryptocurrency market, this was and is a harbinger of difficult and turbulent times for other cryptocurrencies.

Stablecoins, which by definition and design are supposed to provide a uniform and relatively predictable, stable price against some underlying asset or fiat currency, have also been adversely affected. This is in part due to the fact that the leading use case for the largest stablecoins, by market cap, is as a hedging instrument. Readers may know that I recently led a research project into the feasibility of stablecoins as a payment method, and as our report shows, traders and institutional investors use stablecoins first and foremost to lock in their gains from positional trades in the most broadly traded digital currencies on the market.

One particular stablecoin, UST or TerraUSD, has seen its value plummet since early May, and it is not an exaggeration to state that this has brought the viability of stablecoins in general into question.

Swan-Diving Onto Jagged Rocks

When we conducted our research, less than 4 months ago, UST accounted for about 7.5% of the overall market share for stablecoins and was the 4th largest stablecoin by market cap.

Since early May, the Terra blockchain has forked, and UST now trades as USTC with a price of US$0.07 or so. The Luna Foundation Guard (LFG) saw a collapse in its reserves, the Terra ecosystem has taken a severe hit to its reputation, and entire fortunes have evaporated.

There is no point in sugarcoating the situation. This has been nothing short of a disaster in crypto markets.

Several questions naturally arise from this rather sad episode:

1. What caused the failure of UST?
2. What will happen with stablecoins in general?
3. Most importantly, does the failure of UST necessitate a reexamination of the fundamental ideas behind stablecoins themselves?

These questions require honest reflection and straightforward answers. While cryptocurrencies in general are well on their way to fulfilling their original promise, failures like these will happen again, and lessons from this one must be learned and absorbed to avoid even more costly mistakes in future.

The Original Terra Concept

To understand why UST crashed, we must first understand what UST itself actually is. This issue goes to the heart of what stablecoins are designed to do, and whether their design is appropriate for those tasks.

Briefly, UST is – or, perhaps more accurately, was – a stablecoin linked to the value of the US dollar. The largest stablecoins by market cap, such as Tether’s USDT or Circle’s USDC, (supposedly) hold “actual” fiat currency held in reserve against each and every token issued.

Quite how trustworthy these reserves are, is a matter open to vigourous debate. Recall that the US Commodities and Futures Trading Commision (CFTC) fined Tether and its parent, Bitfinex, US$42.5M last year “for making untrue or misleading statements and omissions of material fact in connection with the U.S. dollar tether token (USDT) stablecoin”. In fact, USDT’s reserve base consists of substantial quantities of risky and illiquid assets, including commercial paper and loans. As our research points out, the market does not seem to be particularly concerned with the question of USDT’s reserve base, or with that of any other fiat-backed stablecoin.

In order to get around this issue of reserve quality, UST uses instead an algorithmic approach to regulating its value. This approach “mints” and “burns” the supply of LUNA in response to changes away from the targeted peg of US$1 per Terra token.

The Daemon of Our Own Design

An examination of the original Terra White Paper provides very useful insights into the way this happens. The LFG designed UST to use an arbitrage-based design, in which moves away from the US$1 peg could be arbitraged away rapidly by trading in the volatile cryptocurrency, Terra Luna (LUNA). Both UST and LUNA are intrinsically and inversely linked, so that changes in the price of UST affect the supply of LUNA.

When the price of UST drops below US$1 due to selling pressure in the market, the protocol creates LUNA tokens, which can only be done by reducing the overall supply of UST.

Contrariwise, when the price of UST rises above US$1 due to buying pressure, the protocol destroys LUNA tokens, and that can only be done by expanding the overall supply of UST.

The resulting mechanism is elegant in its simplicity and disciplined in its execution, as (in theory, at least) it ensures that market forces maintain the price of UST at US$1 per token in the market itself.

There is, however, a fatal flaw in this otherwise clean logic, and it lies in the fact that the price of UST depends entirely on the viability of LUNA. If LUNA were to lose credibility or experience a severe price drop, this could potentially trigger a form of “bank run” on UST, thereby creating a “death spiral” from which there could be no recovery.

If It’s Too Good to be True…

This is precisely what happened. For reasons that are still not entirely clear, on May 9th, 2022, hundreds of millions of dollars worth of UST were suddenly sold in mere moments on the Terra blockchain. The algorithmic design of UST requires that, when demand for UST suddenly drops and breaks the US$1 peg, supply of UST must drop in order to offset the drop in demand and maintain the $1 parity.

The only way to do this in the Terra world is to mint LUNA tokens, thus increasing the overall supply of LUNA and reducing the overall supply of UST.

This is where the Anchor Protocol comes into play. Anchor is a Decentralised Finance (DeFi) protocol built on top of the Terra blockchain, acting as a kind of banking system, which at the time offered a 19.5% APY on deposits of UST. I must note here that this practice of offering high yields to holders of stablecoins to deposit those tokens is not new or abnormal – in fact, as our research shows, there is substantial demand from institutional investors for high-quality stablecoins in a tight, limited-supply market for them, and those institutional investors are quite willing to pay high yields to holders of stablecoins such as USDC and BUSD.

The catch here is the eye-popping 19.5% APY, when the risk-free 1Y US Treasury Bill rate at that time was less than 2%. This is extreme by any measure. Financial products linked to USDC, for instance, only yielded a maximum of 7% even in February, and now only yield 1% for 12-month fixed-rate deposits.

The only way for Anchor to maintain this extremely high yield for those willing to “stake” – i.e., invest in – UST, was by eating into its own reserves, and thereby the LFG’s cash and crypto reserve base.

The key problem here is that Anchor offered such an extraordinarily high APY to give investors a reason to put their money into UST. This forced the destruction of LUNA and pushed the price of LUNA upwards, in order to maintain the price parity of UST (see above). As a result, LUNA’s price at its peak hit US$119.18 per token – with absolutely nothing backing it.

Not for the first time in the world of cryptocurrencies, and assuredly not for the last, the high price of this digital asset was an artificial construct. And artificial constructs always – ALWAYS – collapse.

Herein lies the single most important lesson of cryptocurrencies in general – if it seems way too good to be true, IT IS.

How It All Fell Apart

The endgame was as brutal as it was unavoidable. On May 7th, 2022, the Anchor protocol saw over US$2B in withdrawals for reasons that are not yet fully known. Much of that was sold. The selling pressure dropped demand for UST, which immediately triggered a need to “burn” UST by “minting” LUNA.

However, because of specific algorithmic limits on how much LUNA and UST can be created or destroyed in a given 24hr day, panic ensued in the markets and a kind of digital bank run developed. Investors were desperate to withdraw their holdings from Anchor and move their UST into other, more “trustworthy” stablecoins. More and more Luna had to be created, thereby dropping the price of LUNA, just to maintain the peg.

Bank runs are truly deadly once they get started. Anyone who was around to observe the Global Financial Crisis in 2008 (and, given that I was working in midtown Manhattan at that precise time, I had more-or-less floor seats to that particular train-wreck) will remember just how quickly things collapsed for Northern Rock, Bear Stearns, and Lehman Bros. Attempts to stem the collapse rapidly become self-defeating, because trust, once destroyed, cannot easily be rebuilt.

Implications for Stablecoins

By this point, over US$17B in investments have been destroyed by the collapse of the UST-LUNA ecosystem. The credibility of stablecoins as a whole is under serious scrutiny. And the viability of multiple blockchain ecosystems is now a source of worry for investors, users, and developers alike.

Based on our research report and subsequent data, here are some likely broader consequences from the UST crash.

1. Physical Collateral Still Wins

The overriding lesson of the past 6 months, beyond the world of cryptocurrencies, is that physical things dictate economic power. This has always been true, but we have allowed ourselves to forget it. So too it is with stablecoins – those coins which have actual verifiable deposits behind them, are much more trustworthy than those managed by an algorithm, no matter how sophisticated.

That is why fiat-backed stablecoins like USDT, and especially USDC and BUSD, are likely to survive, thrive, and expand their market dominance – because they are linked to objects with value that can be used for something.

2. Narratives Never Last

The narrative behind UST was a compelling one – to create a truly decentralised digital currency that cannot be controlled by anyone or anything, allowing for something approaching total freedom and independence. In the real world, unfortunately, there is no such thing as total autonomy from anything. Every interlinked system has dependencies, and the more tightly coupled those dependencies, the faster and more viciously they fail. This was true in 2008 – it is even more true today.

3. Stablecoins for Payments Need Reliable Backing

Our research focused specifically on stablecoins for payments, and in our work, we made our position on algorithmic stablecoins very clear: we did not consider them to be viable for broad-based consumer payments. The Terra collapse has vindicated this point of view thoroughly.

In my personal opinion, stablecoins can and will be adopted for a variety of payment applications, such as cross-border transfers, online gaming rewards, and point-of-sale payments. But only stablecoins that have real assets backing them up, and which can be verified as such, can be viable for these applications. Anything else should be viewed as impractical, and possibly dangerous.

4. Fiat-Backed Stablecoins Are Not Immune

With, admittedly, the benefit of hindsight, there were clearly severe flaws in the UST-LUNA algorithmic arbitrage design. But backing such coins with physical holdings of fiat currencies is not a bulletproof solution. Already we can observe attempts to put short-selling pressure on USDT, which has been trading below US$1 ever since UST crashed on May 9th. If trust in the reserve bases of fiat-backed stablecoins breaks, then the whole market breaks and even USDT, USDC, and BUSD might conceivably collapse. Given USDT’s position as the undisputed market leader with roughly 40% of the entire market share for all stablecoins, that would be cataclysmic for the market.

5. Fiat Currencies Themselves are Increasingly Unstable

Beyond fiat-linked stablecoins, Western fiat currencies themselves are under serious pressure. Amazingly foolish economic policies in the Western world have expanded the money supply in the USA and EU to unprecedented levels, causing historic inflation and severe macroeconomic shocks. In simple language, central banks in the West have debased their currencies. They are doing with fiat money much the same thing that the LFG did with LUNA to preserve the value of UST, and the results of that debasement will be just as inevitable. There is NO example in history of a fiat currency, based on nothing but “full faith and credit”, that has held its value, for the very simple reason that, if you make more of something than a market needs, you therefore inevitably reduce its worth.

Conclusions

Failure is costly and extremely painful. It is also necessary in order to learn and grow. The failure of Terra’s UST-LUNA approach had a number of clear root causes, which I have gone over briefly. This failure should teach us all to be fundamentally wary of promises of outsize returns, market hype, narratives, and highly interdependent or tightly coupled systems.

Only by learning these lessons, can the full promise of stablecoins in payments be realised. As our research has shown, there are both real and potential markets for stablecoin-based payments, and our estimate of the market size of US$4.45B or so by the end of 2022 is, in my view, still realistic, given that the UST crash resulted from overly generous promises, speculative pressure, and fundamental design. Fiat-backed stablecoins do not share these issues, and have the added advantage of being linked to real, fungible currencies that meet the full definitions of money.

Ultimately, the success or failure of stablecoins for payments will depend on how well developers and investors adapt to rapidly changing market conditions. Already we see signs of adaptation and self-correcting behaviour, which bodes well for the future of stablecoins as a payment method.