Blockchain, Tokens, Africa — Stable Coin Fiasco.
Part 2 — Collapse of the UST Stable Coin.
The last week was very eventful in the Crypto world. We saw the BTC drop from $39,000 on 5th May 2022 to a low of 26,000 on 12th May 2022.
The Fed announcement on 4th May could have triggered this downward market movement as capital took flight from risky assets. Amidst this downturn, there is the story of TerraUST and Luna minted on the Terra blockchain.
In just one week, we have seen the total capitulation of TerraUST and Luna in events that can be described as cataclysmic for holders of UST and Luna coins.
I was intrigued by these events and decided to dig a bit to understsnd how the TerraUST peg to the dollar worked.
Objectives of the Terra Blockchain
Terra is a decentralised blockchain designed to offer a solution for the demand for decentralised, price-stable money protocol in both fiat and blockchain economies. Terra founders believe that if such a protocol succeeds, it will have a significant impact as the best use case for cryptocurrencies. (terra money white paper).
In simple terms, a TerraStable coin is an algorithmic stable coin that does not need the backing of centralised assets like fiat, bonds, corporate paper etc. It sorely depends on arbitrage mechanisms to peg itself to the dollar.
What is a stable coin?
It is widely agreed that stable coins are Crypto-assets whose values are linked or referenced to an underlying asset, e.g. securities or fiat currencies. This means one can create a Token that is pegged to a fiat currency.
Mobile Money is the best analogy for someone living in Africa and is unfamiliar with stable coins. Mobile Money operators are, in essence, e-money issuers. For every unit of money a Mobile money operator has in a mobile money wallet (issued), they are required to hold the same unit of money in a Trust account in a commercial bank. This one to one peg of e-money to fiat money in many African jurisdictions is mandated by payments laws and regulations. The difference between e-money and an on-chain stable coin is that mobile money networks are not decentralised ledgers and don’t come with native crypto tokens bolted on to them.
What is an algorithmic stable coin?
Algorithmic stable coins attempt to issue coins pegged to fiat through algorithms coded into smart contracts. This model attempts to issue a stable coin that is not dependent on any central authority. This coin essentially self pegs to a fiat currency of choice. The argument is that if a stable coin is backed by fiat sitting in a commercial bank account, it follows that the bank can be sanctioned by the state and have the funds backing the stable coin frozen, for example. To this end, the utopia is to create an algorthmic stablecoin that is truly decentralised.
Terra Stable Coin Peg Mechanism.
The Terra whitepaper points out that the Terra Protocol attempts to solve this problem by having an elastic monetary policy that would maintain a stable price. The white paper also points out that price stability is not the only objective. The second objective is to ensure adoption, which is a consequence of network effects.
To this end, the paper proposes that the Terra protocol will implement strong incentives for users to join the network with an efficient fiscal spending regime managed by a treasury. This is noted by the 20% APY the protocol was paying out to Luna stakers.
Fiat Assets Peged to Terra.
Terra is designed to have a family of cryptocurrencies pegged to the various currencies, USD, EUR, CNY, JPY, GBP, KRW, and the IMF SDR. The white paper states that TerraSDR will be the flagship currency of this family, given that it exhibits the lowest volatility against anyone fiat currency.
The Terraprotocol supports atomic swaps between these currencies at their market exchange rates. The vision was to have more currencies added to the protocol to become an instant solution to cross border transactions and international trade settlements.
How Does the Protocol Know the Price of the Pegged Currencies?
Since the price of the Terra pegged currencies is exogenous to the Terra blockchain, the protocol relies on a decentralised price oracle to estimate the true exchange rate. This price estimation is done by miners submitting a vote on what they believe is the current exchange rate in the target fiat asset. On every n block, the vote is tallied by taking the weighted medians as the true rates. Some amount of Terra is rewarded to those who voted within one standard deviation of the elected median. Those who voted outside may be punished by slashing their stakes.
How Is the Peg Maintained?
The Terra money market follows the same simple supply and demand rules as any other market. When the protocol detects that a Terra currency’s price has drifted from its peg, it must apply pressures to bring the price back into balance. It does this by expanding and contracting the money supply.
Contracting the money supply means that money has to be bought from the market. In the traditional sense, Central banks shoulder the cost of absorbing money from the market through various mechanisms, including interest rate hikes, issuance of bonds etc. In the Terra Protocol, Miners would be responsible for absorbing this cost. During a contraction, Miners absorb costs through mining power dilution. This dilution happens when the protocol mints and auctions more mining power to buy back and burn Terra. This contracts the supply of Terra until its price has returned to the peg.
How does it work exactly?
The Terra blockchain native coin is Luna. Luna is analogous to bitcoin in the Bitcoin blockchain. Terra is a proof of stake chain, and as such, Miners need to stake Luna for them to be elected by the protocol to produce the next block. The block producer election is weighted by the size of the stake held by a Miner. Luna, therefore, represents mining power on the network. Luna also serves as a defence against the price fluctuations of Terra. The protocol uses Luna to balance out the price of Terra by agreeing to be the counterparty to Swap Terra and Luna at an agreed exchange rate.
>> If the TerraSDR price < 1 SDR, users and arbitragers can send 1 TerraSDR to the protocol and receive 1 SDR worth of Luna.
>> If the TerraSDR price > 1 SDR, users and arbitragers can send 1 SDR worth of Luna to the protocol and receive 1 TerraSDR.
In simple terms.
Remember, the objective is to keep UST pegged at 1 $. So if the price of 1 UST goes below $1, say, for example, $0.99, you can sell this UST to the protocol and redeem $1 worth of Luna making a profit of $0.01.
This transaction done by many users who want to make this margin creates demand for UST, and as demand and supply laws state, the price of 1 UST will rise and most probably go above the price of $1.
If the price of 1 UST goes above $1, say, for example, $1.01, you can sell $1 worth of Luna to get 1 UST, making a margin of $0.01. If many users ape-in into this trade, the price of Luna will go up, and the price of UST will go down.
Luna’s price decrease is problematic to Miners because they have their stakes locked in Luna. As the protocol mints Luna to meet the demand for UST, the price of Luna goes down. The protocol burns a portion of the Luna earned during expansions until the Luna supply has reached its 1 billion equilibrium issuance.