Everyone wants to become the Federal Reserve issuing money to all over the world and taking seigniorage. Over-issued money has other countries to pay together. Terra was once named the Federal Reserve of the algorithmic stablecoin world, but ends in tragedy that Terra’s native token, Luna and UST, total market cap of more than 40 billion evaporated in a few days, which made people sigh. In this article, we will discuss the essential reasons for Terra's collapse and the design of stablecoins of new public chains from the perspective of monetary policy.
1. Terra Introduction
In view of the opaque collateral behind centralized stablecoins such as USDT and USDC, and the low capital efficiency of decentralized stablecoins such as DAI and MIM, which are minted using over-collateralization, Terra proposes a new algorithmic stablecoin mechanism. There are already many excellent articles that introduce Terra in detail, this article mainly from the perspective of Monetary Policy to discuss the stability of stablecoins, so do not do too much description of Terra. Simply put, Terra is a series of stablecoins using algorithms to maintain the peg of fiat money. The most traded stablecoin in circulation is UST of which value is pegged 1:1 to the US dollar, so the stablecoins of Terra later in this paper refer to UST. The arbitrage mechanism for the Terra stablecoin to maintain its peg is as follows: Terra uses a dual token mechanism, Luna and UST, where the price of Luna is free to fluctuate, and the UST is pegged to the U.S. dollar. Luna is used to absorb the volatility of UST’s price. Assume that currently 1 Luna = 100 $:
- When 1 UST = 1.2$, users can spend 100 $ to buy 1 Luna for burning and minting 100 UST, after selling 100 UST, you can get 120 $ and make a profit of 20$. As more and more people in the market participate in arbitrage, it will eventually make 1 UST = 1$, which brings the result that Luna circulation decreases and the price increases, and UST circulation increases and the price decreases, manifesting as the expansion of stablecoins.
- When 1 UST = 0.8 U, users can spend 100 U to buy 125 UST for burning and minting 1.25 Luna, after selling it, you can get 125 $ and make a profit of 25 $. As more and more people in the market participate in arbitrage, it will eventually make 1 UST = 1 U, bringing the result that Luna circulation increases and the price decreases, and UST circulation decreases and the price increases, manifesting as the tightening of stablecoins.
2. Looking back at the breakdown
2.1 Premise
On the eve of the “5.7” crash, UST's total market cap was 18.7 billion, approaching Luna's market cap of 23.4 billion. The entire Terra ecosystem is overleveraged as a prerequisite for successful UST sniping.
2.2 Timing
In order to increase Curve 4 pool (UST - USDT - USDC - Frax) liquidity to crowd out competitor DAI, Terra team removed 150 million UST liquidity from Curve UST-3Crv (USDT - USDC - DAI) and prepared to move to the 4 pool. Leaving short sellers the opportunity to attack UST - 3Crv at low cost.
2.3 Action
Subsequently, 85 million of UST were transferred to Curve and exchanged to USDC, followed by a large number of addresses joining the UST smashing army, resulting in a serious imbalance in UST-3Crv pool, and then UST lost its peg.
2.4 Defense
In order to maintain UST’s peg to the dollar again, the team sold over 50,000 ETH to Curve and transfered 20,000 ETH to Binance, put the UST-3Crv pool back into balance. A large amount of Terra’s ETH was exchanged via stETH, which subsequently triggered market concerns about stETH depeg.
2.5 Breakdown
Thus the money battled back and forth several times, Terra team consumed most of the money. A large amount of UST was redeemed from Anchor, as Anchor redeemed UST don’t need a lock-in period which could give the team a buffer, a large amount of UST was redeemed from Anchor and slammed into the market, causing further depeg of UST. UST losing peg pushed arbitrageurs to burn UST for minting Luna and sell Luna into the market, causing the price of Luna to plummet. Since the number of USTs that can be used to cast Luna at low spreads is limited each day, the exchange spread will increase beyond a certain limit, making fewer arbitrageurs. Therefore, the degree of UST depeg is related to the arbitrage spread. When the arbitrage spread appears, it is difficult to bring UST peg back to normal level through arbitrageurs' arbitrage, and UST decoupling takes too long, further illuminating UST credit loss, and more USTs will smash into the market and mint Luna into the market. When the market value of Luna is less than UST, it further triggers a crisis of confidence, triggering a run and starting a death spiral.
3. Analysis of the intrinsic cause of Terra‘s crash from a monetary perspective
3.1 UST usage scenarios are dysfunctional and funds are idling in the lending market
The use scenarios of a country's currency have consumption, investment and savings internally to promote the internal economic cycle, and consumption and investment externally to export the inflation within the system externally. Comparing each public chain to a country, the stable coin in the public chain should also meet the above five usage scenarios.
Internally:
- Consumption: using stablecoins to purchase goods produced in the ecology, such as purchasing NFT and kryptonite in Gamefi.
- Investing: using stablecoins for intra-ecological investments, such as participating in IDOs and trading on decentralized exchanges (DEX).
- Saving: depositing stablecoins into lending agreements to earn interest.
External:
- Consumption: using stablecoins to purchase consumer goods outside the ecosystem.
- Investment: using stablecoins to purchase underlying outside the ecosystem through cross-chain.
Take a look at Terra's efforts in these five areas.
Internal:
- Consumption: the Terra ecosystem has a small number of projects on NFT and games to meet the consumption needs of users.
- Investment: Mirror is an important investment venue in the Terra ecosystem, offering trading in synthetic assets in US stocks.
- Savings: Anchor plays a role in accumulating savings in the Terra ecosystem.
External:
- Consumption: in cooperation with various payment platforms, such as Chai and Astral, users can purchase off-chain goods while using Terra stablecoins.
- Investment: Through cross-chain bridge, users can go to other public chains for investment and consumption; UST is on the shelves of Binance, FTX and other head exchanges, and users can use UST to buy other cryptocurrencies.
The biggest highlight of UST is the off-chain purchase of commodities and the listing on mainstream exchanges, building a strong barrier for it to compete in the stablecoin market.
Looking at the structure of the five scenarios, on the eve of the collapse, the total UST issuance was 18.7 billion, of which savings had a UST of 14 billion in Anchor, meaning 75% of UST was used for savings. It shows that the other four usage scenarios are difficult to advance, leading to an excessive saving rate in the whole ecosystem and an extremely unbalanced structure of the whole money circulation. Thus, Anchor is the culprit driving the Terra eco-collapse.
Anchor introduced a 20% fixed deposit rate due to the high volatility of the APY in the Defi market. At the same time, to incentivize users to borrow, loan users were given a subsidy to borrow at negative rates. When the overall deposit rate in the Defi market dropped, Anchor did not lower their deposit rate and remove the loan subsidy, so lenders had no better place to go after lending USTs and had to deposit them in Anchor. Funds were idled throughout the savings and loan system, further increasing Terra Eco's leverage until UST's market capitalization approached that of Luna. High money issuance did not bring low-interest rates and high investment effects, and funds did not flow to other application scenarios of the ecosystem. This corresponds to the reality that when the high social financing scale does not bring economic growth, funds are idling in the financial system, which will increase the overall systemic risk.
3.2 The transmission mechanism is blocked and cannot spontaneously regulate the money supply
Fixed exchange rate system, free flow of capital, and independence of monetary policy is the classic monetary trilemma. Taking two of them will necessarily require giving up the third. The primary goal of stablecoin is to maintain their peg, while the free flow between public chains through cross-chain bridges, which is equivalent to a country adopting a fixed exchange rate system under the free flow of capital, will inevitably lose its independence of monetary policy.
Terra controls the deposit rate through Anchor. When Terra over-issues money, interest rate regulation is blocked and cannot spontaneously adjust to reduce the money supply through the transmission mechanism, which ultimately affects the achievement of monetary policy objectives. In fact, the team, as the largest holder of Luna, has the most incentive to do the operation of over-issuing money. This can make Luna further deflate and quickly pull up its market value. On the other hand, using high yield bonds as a reservoir for over-issuing money raises the overall TVL of Terra’s ecosystem, which improves the overall valuation of Luna.
3.3 Lack of liquidity accelerates the death spiral
In the Terra ecosystem, UST is equivalent to a convertible bond with a face value of 1$ and Luna is equivalent to equity. In terms of transmission mechanism, Luna is only used to absorb the volatility of UST and the price movement of Luna does not lead to UST’s depeg. Luna is not a reflection of UST reserves, but of debt liquidity. Liquidity is the ability to liquidate assets without loss. The liquidity of UST is the maximum of the liquidity of the secondary market for UST and the liquidity of Luna. Secondary market liquidity is primarily in Curve and the exchanges. When UST’s price is lower than 1$, UST liquidity decreases and relies on Luna's liquidity. When the market value of Luna is lower than the market value of UST, it means that the liquidity of Luna is not sufficient to repay the debt of UST, and the UST debt liquidation must suffer a loss.
When Terra is in significant default, it is necessary to scale down the balance sheet and expand the asset side. The team converts the UST in their hand, or the UST repurchased at a discount into Luna, and brings Luna to the market to complete the drawdown balance sheet and expand the asset side. The continuous issuance of Luna leads to unsafety of Terra network, which is prone to governance attacks and makes Luna lose its public chain value, further reducing Luna's valuation.
4. Design Thinking of New Public Chain Stablecoins
Emerging market countries often trigger emerging market risks due to improper use of monetary policies. More and more new public chains have risen in recent years, and the new public chains are like one emerging market country, whose stablecoin design is the easiest link to accumulate systemic risks. In order to avoid the situation that one stablecoin protocol drags down the whole public chain, the following two points are proposed to think about the design of new public chain stablecoin.
4.1 Decentralization of coinage
Just as every president will want to adopt expansionary policies to boost the economy during his or her term of office, it is important to ensure that the monetary policy is made without the influence of the government. The public chain team has a great incentive to do monetary overdraft, but under the fixed exchange rate and free flow of capital, it is impossible to achieve monetary overdraft, so the team will do some intervention to make the whole monetary transmission mechanism not smooth and accumulate systemic risk to the public chain. Therefore, it is necessary to put the issuing right below, and multiple counting stablecoin protocols in the ecosystem compete together to reduce the impact of stablecoin protocol collapse to the whole public chain ecosystem. Being unable to use expansionary monetary policy and turning to expansionary fiscal policy, such as ecosystem fund to reward project parties (engage in infrastructure), lowering Gas (lower tax), and giving airdrop to deep users (improve the welfare level of residents), etc. Expansionary fiscal policy will be better for the economic construction of the whole ecosystem and users.
4.2 Reducing the risk of stablecoin protocols correlates with new public chain native token
In order to avoid the death spiral effect brought by the stablecoin crash, the stablecoin protocols of new public chains should use less the chain’s native tokens as reserves to reduce the correlation between the protocol risk and public chain risk, so as to avoid the death spiral. Stablecoins issued with new public chain native token as collateral will have more new public chain native token redeemed and smashed into the market when the stablecoin is losing peg, which will easily trigger the death spiral of stablecoin protocols and public chain native token when the stablecoin occupies an important position in the ecosystem.
Summary
The world of Web 3 is rapidly iterating every day. With the breakdown of Terra, there will still be millions of "Terra" contributing their wisdom to the field of algorithmic stablecoin. Designers and investors should delve deeper into the kernel principles of monetary policy to avoid Ponzi scheme in the guise of algorithmic stablecoins. Looking forward to a more mature and stable stablecoin solution emerging in the near future.
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