Stablecoins have become the foundation of the decentralized finance (DeFi) ecosystem. Rather than dealing in dollars, most decentralized exchanges settle transactions in Tether, USDC, or other stablecoins with a dollar peg. But unfortunately, some stablecoins are proving to be less stable than their name implies—especially with Terra’s recent fall.
Let’s take a look at Terra, Luna, and the fall of one of the most successful stablecoin projects earlier this year.
Algorithmic stablecoins experienced a setback with the collapse of UST and LUNA in May 2022—here’s what happened.
What Are Terra and Luna?
Do Kwon, a South Korean Stanford computer science grad, founded Terra in April 2019. According to the whitepaper, Terra was built to fulfill Bitcoin’s original goal of becoming a peer-to-peer electronic cash system. The idea was to create a price-stable and growth-driven cryptocurrency that could serve as a stablecoin without the need for a reserve.
The system works by using a smart contract to keep the price of TerraUSD (UST) anchored to USD$1.00 by burning LUNA tokens to mint new UST tokens. For instance, if UST’s price rose above USD$1.00, LUNA holders could earn a risk-free profit by swapping USD$1.00 worth of LUNA to create one UST token, resulting in UST dilution and a lower price.
If the price of UST fell below USD$1.00, UST holders could earn a risk-free return by swapping their UST at a 1:1 ratio for LUNA. By burning UST in the process, its price would eventually increase to USD$1.00. These arbitrage opportunities were designed to keep UST’s peg at exactly USD$1.00, making it a reserve-free stablecoin.
Terra didn’t take off until the launch of Anchor as a quasi-bank for crypto where users would deposit UST and earn 20% interest. After the launch in 2021, LUNA’s price rose 100-fold, and nearly $10 billion UST stablecoins came into existence. And, the stablecoin became the fourth largest by market capitalization after Tether, USDC, and Binance USD.
How Did Terra Collapse?
Terra and other stablecoins never maintain a perfect peg with the U.S. dollar. For instance, in May 2022, UST fell as low as $0.96 before recouping its losses. However, the wider fall in cryptocurrencies sparked a run on the Terra ecosystem in early May. And, as the price of LUNA and UST fell, investors lost confidence in the peg.
By mid-May, there was more than six trillion LUNA in circulation with a price of USD$0.00002. While anyone could theoretically redeem a UST for a huge amount of LUNA worth USD$1.00, the lack of buyers made the tokens worthless in the eyes of the market. As a result, UST’s price fell to less than USD$0.20—a fraction of its pegged value.
As UST and LUNA prices fell, one of the big four exchanges in South Korea suspended trading in LUNA and limited the ability of traders to re-stabilize the ecosystem. In addition, Anchor’s token fell more than 70% and was already on track to deplete its reserves within a few months, creating doubt about its promised ~20% yield.
Terra founder Do Kwon hopes to help restore UST’s peg by increasing LUNA minting by 400% to let more UST holders cash out and increasing the amount of UST that can be sold for LUNA each day. However, the collapse in prices has created a lot of distrust and UST holders aren’t very incentivized to cash out as LUNA tokens continue to fall in value.
Can You Deduct Terra Losses?
Crypto traders and investors that realize a loss on UST or LUNA can use that loss to offset any other capital gains or up to $3,000 of ordinary income. In addition, they may be able to carry forward these losses to future tax years if they cannot use the deduction in the current year, although there are certain limits to keep in mind.
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Impact on the Crypto Ecosystem
Terra’s approach to stablecoins is no longer unique, with Tron and other Layer 1 protocols pursuing similar designs. For instance, during Terra’s collapse in mid-May, Tron launched an algorithmic stablecoin called USDD that operates in much the same way as UST. However, Tron plans to raise $10 billion in assets to use as a reserve to defend the token.
Terra’s collapse also sent shockwaves through the wider crypto ecosystems, highlighting its interconnectedness. In addition to other stablecoins briefly de-pegging, including Tether, most major cryptocurrencies saw a 15% to 25% drop. Many DeFi protocols relying on Terra also experienced losses, including the Venus protocol.
Finally, regulators that were already skeptical of stablecoins have also taken notice of Terra’s downfall. For example, U.S. Treasury Secretary Janet Yellen referenced UST by name when asking Congress to pass legislation to regulate stablecoins. Since many of these stablecoins desire to operate as banks, regulators hope to improve similar rules on them.
In addition to contagion, regulators worry that Tether and similar reserve-backed stablecoins could destabilize the commercial paper market where they keep the majority of their reserves. A crypto-driven sell-off in the commercial paper would impact the wider credit market that relies on the short-term debt for liquidity.
The Bottom Line
Stablecoins have become the foundation for the DeFi ecosystem, but Terra’s algorithmic approach may not be the best method. After experiencing a run on its tokens, the project ultimately collapsed and sent shockwaves throughout the crypto markets. These developments could have a significant impact on the future of stablecoins and other projects.
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