Several market participants, including myself, Lyn Alden, Kevin Zhou, and Adam Back, identified critical flaws in Luna/Terra’s mechanism design that made it susceptible to a hyperinflationary “death spiral.” Anyone who has studied the history of currency pegs understood where this trainwreck was headed.
Decentralized algorithmic stablecoins are an oxymoron and an impossibility. As shown below, they have a history of being anything but stable, as they are always open to an attack.
Let’s start by looking at traditional currency pegs, why countries turn to them, and what risks can arise. By studying currency peg failures of the past, we can better understand how Luna/UST collapse was all but assured.
A pegged currency can reduce volatility and exchange rate risk, allowing individuals and businesses to focus on their pursuits instead of worrying about the stability of their local currency.
The hard part is not pegging the local currency; it’s maintaining the fixed peg as market dynamics change.
One important caveat with a fixed currency peg is that a pegging country must give up its monetary policy autonomy in order to stabilize its local currency and increase trade. This is often referred to as the Mundell-Fleming Trilemma or “the Impossible Trinity”.
When a peg comes under pressure and the currency begins to depreciate, it opens the doors for opportunistic speculators to short the currency, which adds more inflationary pressures to the already weak currency. This dynamic can lead to a scenario where a currency peg breaks, the central bank runs out of its FX reserves to support the peg, the local currency depreciates rapidly, and a full-blown currency crisis ensues.
Central banks have struggled to maintain fixed currency pegs for decades, and have mostly failed. It’s folly to attempt to create artificial stability through a fixed currency peg in a world that is inherently unstable. It’s not a question of if a fixed currency peg will fail, but when.
Stablecoins are best thought of as digital bearer assets that run on public blockchains that aim to peg their price to sovereign fiat currencies to inherit their price stability.
[...] three different forms of stablecoins emerged:
Fiat collateralized — these are backed 1:1, typically by dollars or dollar-equivalent assets in a bank account. You can redeem these coins for dollars held in a bank account and vice versa. (ex: USDC, USDT)
Crypto overcollateralized — another digital asset backs these over the dollar amount of the stablecoin, and in return for depositing, a trader gets a minted stablecoin back. (ex: Maker DAI, BitUSD)
Algorithmic non-collateralized — no collateral backing; instead there is a stabilization mechanism in which the supply is expanded when the peg is too high, and the supply contracts if the peg is too low. (ex: UST, FRAX)
Terraform Labs created artificial demand for UST by offering a 20% yield on UST in the Anchor Protocol, which was also built by Terraform Labs. This yield was primarily funded by Terraform Labs through sales of their Luna token treasury. To avoid collapse, Terraform Labs would need to continually provide funds to the yield reserve to pay the 20% yield to UST holders so they wouldn’t burn their UST for Luna or USD.
Luna had suffered a hyperinflationary event for the ages, the peg had collapsed entirely, and ~40 billion dollars worth of market value was destroyed in days.
Many unknowns still remain around whether or not LFG actually sold the bitcoin in their reserves, or if management retained possession of the bitcoin.
The founders of Terra Luna are at it again. They are currently attempting to resuscitate the failed project by launching Terra 2.0. Why anyone would invest their money with these people again is beyond me.
The truth is the history of currency pegs foreshadowed what would occur with Luna/UST. From the Bank of England to the Bank of Thailand to now Luna/UST, fixed currency pegs are nearly impossible to maintain in this highly complex and rapidly changing world. It was a mixture of hubris, arrogance, greed, and ignorance that led this doomed idea to get off the ground in the first place. We are fortunate the scheme blew up before it grew larger and became more of a systemic risk.
The risk of a major stablecoin blowing up is now behind Bitcoin. It has survived another exogenous threat, and it will continue to do precisely what it was designed to do since its very first block.