Terra Was Called a Stablecoin Until It Went to Zero
An algorithmic stablecoin holding no dollars collapsed in days in May, taking tens of billions of dollars of value with it and triggering the failures that defined the rest of the year.
Two Kinds of Stablecoin
A stablecoin is a token intended to hold a constant value, almost always one United States dollar. There are two fundamentally different ways to attempt that, and conflating them caused an enormous amount of damage in 2022.
The collateralized approach is simple. The issuer holds actual dollars or short term Treasury bills, one for one, and promises redemption. The stability comes from the reserve, and the risk is whether the reserve is real and liquid.
The algorithmic approach holds no reserves. Terra's UST maintained its peg through an arbitrage relationship with a sister token, LUNA. A holder could always exchange one UST for one dollar worth of newly created LUNA, and vice versa. If UST traded below a dollar, arbitrageurs would buy it cheap, swap it for a dollar of LUNA, and profit, which was supposed to push the price back up.
The Circularity
The mechanism works while LUNA has value. That is the entire load bearing assumption, and it is circular, because much of LUNA's value derived from confidence in the UST system it was supposed to backstop.
When UST fell below its peg and holders rushed to exit, the mechanism created enormous quantities of new LUNA to absorb the redemptions. That supply crushed LUNA's price. A falling LUNA price meant more units had to be minted for each UST redeemed, which crushed it further. The stabilizer became the accelerant, and the loop ran to completion in days.
The peg was backed by a token whose value depended on the peg holding. That is not a reserve, it is a promise arranged in a circle.
The Yield That Attracted the Money
UST had grown rapidly because an associated protocol offered a return near 20 percent on deposits. That rate was not generated by lending activity at anything like sufficient scale. It was substantially subsidized from a reserve fund.
A yield that far above the risk free rate is a statement about risk, not a discovery of free money. If an asset advertised as equivalent to a dollar pays twenty times what Treasury bills pay, the correct inference is that it is not equivalent to a dollar. The rate was the disclosure, and it was in plain sight.
The Chain Reaction
The failure did not stop with Terra holders. Several large crypto lenders and a prominent hedge fund had positions connected to Terra, or were funded by short term borrowing against volatile collateral. Those entities failed over the following weeks, and their failures pulled down counterparties in turn.
The structure was a shadow banking system with none of the protections. Firms took deposits, promised yields, lent against volatile collateral, ran maturity mismatches, and operated with no capital requirements, no reserve rules, no deposit insurance, and no lender of last resort. Every failure mode banking regulation was built to prevent was reproduced from scratch.
What Survived
Fully collateralized stablecoins holding Treasury bills continued operating through the period, which is the useful comparison. The problem was never the concept of a token pegged to a dollar. It was the specific claim that a peg could be maintained with no assets behind it.
The Bottom Line
Terra failed because its collateral was a claim on itself, and the twenty percent yield was the warning label. When something pays far above the risk free rate while calling itself risk free, one of those two descriptions is wrong.