Algorithmic stablecoins and the risk of devaluation

On May 10, 2022, TerraUSD, an algorithmic stablecoin operated on the Terra blockchain, dropped in value and lost its peg to one US dollar. Using TerraUSD Peg’s devaluation as a case study, this column shows how algorithmic stabilcoins are vulnerable to speculative attacks when the system is under-collateralized. The authors point to the solution – stable parallelism and extra parallelism – to stabilize the peg.

Stablecoin works on the blockchain and maintains the parity of the US dollar. They usually act as the car currency for trading cryptocurrencies by reducing the cost of intermediaries by working in blockchain. To understand stablecoin design, we use the structure in Figure 1. Of the three objectives – peg stability, decentralization and capital efficiency – only two can be met by a given design.

Figure 1 Stablecoin Trilema

The most common type of stablecoin is the centralized stablecoin, led by Tether, whose balance sheet contains commercial paper and less liquid resources (Lyons and Viswanath-Natraj 2020a). Decentralized (parallel) stablecoins are handled by MakerDAO’s DAI. In this design, individuals issue DAI tokens through additional parallel positions where they deposit cryptocurrency parallels (typically, ETH). Although they are decentralized, they are less capital-efficient than their centralized counterparts (Kozhan and Viswanath-Natraj 2021). The third type is the algorithmic stabilized coin, led by Terra USD, which is usually under collateralized. While this is a more capital-efficient design, it has the drawbacks that they have a tendency to speculate and attack and trade at a big discount (Echengreen 2019).

TerraUSD creation and arbitration

Luna is the native token of the Terra blockchain, and users can burn Lunar $ 1 to create a TerraUSD stablecoin worth US $ 1. Luna tokens are used to block transactions in the blockchain, to pay fees, to fix tokens in governance votes, and to generate revenue in DeFi transaction protocols.

TerraUSD is $ 1 through a simple arbitrage mechanism (Lyons and Viswanath-Natraj 2020b). Consider, for example, the case where the TerraUSD price is above par. In this example, an investor can sell Luna for 1 and buy TerraUSD for 1. They will then be able to sell TerraUSD in the secondary market. Conversely, when the dollar value of TerraUSD is below one, an investor can buy TerraUSD in exchange and sell TerraUSD for una 1 worth of Luna tokens.

A major concern of the arbitrage mechanism is that it is not risk-free; Investors’ profits are driven by expectations of the evaluation of governance tokens. Another problem is that the system is under collateralized. As an insurance against peg discounts, TerraUSD has a bitcoin reserve in the treasury that it can use to support Terra USD peg if there is insufficient luna to meet redemption (Lee and Meyer 2020). We plotted the total reserves in Bitcoin in Figure 2. When Bitcoin’s reserves peaked at 1.8 billion in early May, they reached about 10% of the estimated ra 18 billion TerraUSD market cap. However, on May 10, 2022, Bitcoin’s reserves were completely depleted to protect against a speculative attack.

Figure 2 TerraUSD saves bitcoin to maintain pegs

Note:Bitcoin reserve transactions obtained from: https://bitinfocharts.com/bitcoin/address/ bc1q9d4ywgfnd8h43da5tpcxcn6ajv590cg6d3tg6axemvljvt2k76zs50tv4q

The story of two balances

We show that the under-collateralized system has two balances. On the one hand, user growth in blockchain is growing exponentially. This increases the value of the Governance Token Lunar as well as the demand for TerraUSD stablecoins, which are used in all applications built into the Terra blockchain. In this case, the upward pressure on TerraUSD depends on the following arbitration process: Luna holders burn and sell ুন 1 Mint of Lunar থেকে 1 to Terra Token for profit.

Now consider the opposite case: a big drop in lunar value. TerraUSD Peg is now volatile. Weak fundamentals trigger a speculative attack on Peg, as there is not enough luna to redeem the outstanding value of all equally circulating TerraUSDs. When the TerraUSD peg breaks, it loses confidence in blockchain and governance tokens. This reaction could create a spiral in the fall of Luna and Terra USD prices. The arbitrage loop of redeeming TerraUSD at $ 1 and buying Luna tokens failed because investors lost confidence in the peg stabilizing mechanism.

Peg devaluation on 10 May 2022

We find support for the risk of devaluation in Panel A of Figure 3. There are three events leading up to the big peg discount noticed on May 10, 2022, where TerraUSD had the lowest transaction of 60 cents. A big fall in Bitcoin coincided with the fall in the price of Luna Token as investors canceled all cryptocurrencies.

The ratio of the lunar price to the circulation supply of Terra USD is plotted on panel B in Figure 3. For most peg histories, the ratio is over one, which means investors can always redeem TerraUSD tokens equally. On May 10, the ratio of Luna to TerraUSD market cap is less than 0.5 ৷ Therefore, there is no possible way to redeem all TerraUSDs equally. Peg’s weak fundamentals triggered a speculative attack (Routledge and Zetlin-Jones 2021). The arbitrage mechanism also breaks down when lunar prices fall; Investors are not redeeming TerraUSD tokens and are buying Luna.

Figure 3 TerraUSD price on 10 May 2022

Note:: TerraUSD and Luna’s market cap from Coinmarketcap. UST / USD price data for coinbase exchange is obtained from coinapi.

Can we learn a lesson?

What is the lesson from this episode? First and foremost, algorithmic stablecoins are at risk of devaluation and prone to speculative attacks when they are under-collateralized. A natural solution is to support TerraUSD by a stable parallel, ideally liquid US dollar reserve or blockchain equivalent to a stable coin equivalent. Another solution is to maintain additional collateral through smart contracts. For example, if the ratio of parallelism with stablecoin falls below a threshold, the system needs liquefaction of stablecoin to maintain complete parallelism and peg stability. In fact, at the time of writing this column, the founder of Terra Blockchain has publicly stated that Terra will move to a parallel system.1

Conclusion

This column answers multiple questions regarding whether algorithmic stablecoins are vulnerable to predictable attacks. We found support for the risk of devaluation in a case study of the algorithmic stablecoin TerraUSD on 10 May 2022. Stablecoin is risky for a speculative attack when it is parallel. The devaluation risk is increased when the stable coin supply is linked to the evaluation of the blockchain governance token. We suggest alternative solutions, such as being supported by liquid stable parallel type or arranging additional parallelism through smart contract to achieve peg stability.

References

Eichengreen, B (2019), “From product to fiat and now to crypto: what does history tell us?”, Technical Report, National Bureau of Economic Research.

Eichengreen, B and G Bishwanath-Natraj (2022), “Stablecoin and Central Bank Digital Currency: Policy and Regulatory Challenges”, Asian Economic Papers 21 (1): 29-46.

Kojan, R. and Bishwanath-Natraj (2021), “Decentralized Stablecoins and Parallel Risks”, WBS Finance Group Research Paper, forthcoming.

Lee, Y. and S. Mayer (2020), “Making Money in Decentralized Financing: A Dynamic Model of Stablecoin and Crypto Shadow Banking”, Fisher College of Business Working Paper 2020-03.

Lyons, RK and G. Bishwanath-Natraj (2020a), “What keeps stable coins stable?”, Technical Report, National Bureau of Economic Research 2020.

Lyons, RK and G Viswanath-Natraj (2020b), “Fixed Coins Do Not Inflate the Crypto Market”, VoxEU.org, 17 April.

Routledge, B and A Zetlin-Jones (2021), “Currency Stability Using Blockchain Technology,” Journal of Economic Dynamics and Control104155.

Endnote

1 https://twitter.com/stablekwon/status/1524331190995484672?t=pf-Gfwt5D-zdjIo_2AOzCg&s=19

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