Trouble in Terra Town

After holding up well against hoards of trouble and turbulence, the crypto market is finally heading south in a big way.

The crypto royalty — that’s Bitcoin and Ethereum — went more than -10% lower today. With that, the world’s largest cryptocurrencies are down more than a fifth this week. 

And when the royalty are unwell, so are its loyal subjects. Solana is down -14%, Cardano is down -15%, Avalanche is down -15% …

… and TerraUSD is down -26%. Yeah, this market is so bad that even stablecoins are turning into sh*tcoins.

For the unacquainted, this probably makes very little sense — but TerraUSD ($UST), the crypto market’s star-studded algorithmic stablecoin, is perhaps the star of today’s show. Its close compatriot, the Terra blockchain, is also nominated for its role as a supporting actor.

So, what gives? How come an asset that is supposed to be worth a dollar is trading more than 10 cents below its peg? 

UST, unlike other stablecoins, is an algorithmic stablecoin. Algorithmic stablecoins are distinct in the way that they maintain stability. They are in a completely different class than USDC — which relies on actual cash and cash equivalent reserves held by centralized organizations — and DAI — which is minted using over-collateralized loans.

What makes it different is its reliance on software. $UST uses programmatic rules to maintain its desired price, which in this case is $1.00. When $UST drops below a dollar, like it did today, it burns $UST and mints the Terra chain’s crypto ($LUNA.X). When the price rises back to parity, it stops doing this. If UST ever exceeds $1.00, it does the opposite — it burns $LUNA.X and mints $UST.

There’s just one big problem. Well, actually three… and maybe even more that don’t immediately come to mind. Those three are market volatility, FUD, and legitimate concerns about the software and its ability to restore the peg. The first two are sort of “sunk costs” from becoming a crypto investor, but the latter deserves underscoring.

Ultimately, $UST relies on the price of $LUNA.X in order to stay afloat. $LUNA.X is down more than -40% today, which is contributing to some major headwinds as the stablecoin’s software tries to claw back to $1.00.

Another factor complicating this entire already complicated situation is $LUNA.X‘s market capitalization falling below those of TerraUSD. In other words, there is more $UST in circulation than there is $LUNA.X.

Does this mean Armageddon for $UST and Terra? Well, not yet… but it’s less than ideal.  It has spent most of today in flux, trading between $0.80 and $0.95. Neither figure is a dollar, so one could say that UST is failing to maintain its namesake “stable” status.

However, this is not the first time that this has happened with UST; certainly not the first time that an algorithmic stablecoin has struggled to stay stable. $UST depegged in a dramatic incident nearly a year ago, falling as low as 94 cents. There was only $2 billion worth of UST in circulation at the time. Today, its outsized influence in the crypto space cannot be underscored enough… and there are now $18 billion worth of UST on the line.

Beyond its own history, the crypto space has seen depegging incidents galore in the burgeoning and risky world of algorithmic stablecoins. Several months ago, an algo stablecoin called Magic Internet Money suffered a depegging incident after the project was shown to have close associations with an alleged convict.

At least in $MIM’s case, it was able to recover the peg. Some aspirational stables have not been so lucky. Take Beanstalk, a new “credit-based stablecoin protocol”,  which lost more than $182 million of crypto after a hack as an example.

Either way the cookie crumbles, TerraUSD is facing a crisis of confidence from investors. Over $2.8 billion of UST has been traded in the last 24 hours, and as you can imagine… the bulk of it is capital heading for the door. IHowever, after this period of volatility, $UST’s software might regain the upper hand in the market (and we’ll talk about how Terra’s team is trying to help it do just that.)

However, as of right now, things are looking very dark: $UST traded at $0.7337 at the time of publication.

Hopefully by now, it’s pretty obvious that there’s a problem with $UST — a pretty big one.

However, investors are now wondering what it will take for the stablecoin to regain the upper hand. Unfortunately, the software might need some help from Terra’s trusty foundation, the Luna Foundation Guard (LFG).

Not too long ago, the Terra chain’s founder — Do Kwon — and the LFG had lofty ambitions to become the world’s second-largest holder of Bitcoin. They also implicitly suggested that using Bitcoin to collateralize $UST would follow. However, the LFG unfolded its long Bitcoin position today in an effort to find stable ground.

As part of that unfolding, the LFG announced today that it would loan out $750 million worth of Bitcoin to OTC firms, which will manage and trade the capital. And on the flipside, the LFG will take a 750 million UST loan to rebalance its reserves.

In total, Do Kwon and Terra’s guard are issuing roughly $1.5 billion in loans which are denominated in both Bitcoin and UST to help float them over this market-shaking speedbump. 

The question is: will it work?

With UST looking prime to head below $0.70, 750 million UST might not be enough to paint over the exodus from the chain. In fact, with $UST’s market capitalization higher than $LUNA.X’s, things look bound to get uglier.

It’s too early to rule out whether or not the LFG will have to take more evasive actions. But, if you take a step back here, what we’re talking about right now is a massive, multi-billion dollar debasing of one of crypto’s largest stable assets. These implications aren’t just endemic to the Terra blockchain, which is one of the top 10 blockchains by market cap, but to the entirety of decentralized finance (DeFi) — mostly because $UST has become an extremely common pair across chains.

As Steven Goulden, a senior research analyst at Cumberland DRW, said in a Bloomberg report published about Do Kwon and the LFG’s effort: “We’re watching carefully to see how the market fares over the next 24 hours … including whether mechanisms … will be enough to hold in times of deep stress or if we need additional stabilization mechanisms.”