Terra and Luna
An algorithmic stablecoin lost its dollar peg within days in May 2022. Both involved tokens fell to practically zero, wiping out a value in the tens of billions.
A stablecoin is supposed to always be worth a dollar. Most achieve that by actually holding dollars in reserve. Terra did it differently: the peg was meant to work through a mechanism involving a second token called Luna.
Simplified: if Terra fell below a dollar, it could be swapped for newly created Luna. That was supposed to stabilize the price. On top of that, a program offering roughly twenty percent yield drove a large share of demand.
In May 2022, the peg started slipping. The mechanism kept creating more Luna, which pushed down its price, which further destroyed confidence in Terra. Within days, both were practically worthless.
This is exactly what the lesson on yield promises warns about. Nobody could plausibly explain who was generating that twenty percent. Where such an explanation is missing, the return comes from the next round of depositors, and that always ends the same way.
The mechanism rested on a feedback loop between two tokens with no external collateral. Such constructions are stable as long as demand grows, and unstable the moment it falls: support comes from issuing the second token, whose price falls as a result, requiring even more of it to be issued. This self-reinforcing dynamic is described as a death spiral.
The roughly twenty-percent yield didn't come from operating earnings, it came mostly from a reserve set aside for that purpose. The program was therefore a subsidy of demand, one whose end was foreseeable. Demand created purely by a subsidized yield disappears along with the subsidy.
A systematic distinction is needed between collateralized stablecoins backed by deposited short-term assets, overcollateralized constructions backed by crypto collateral, and algorithmic models with no external backing. Only the first two have support outside their own system. The third category has proven unviable in multiple attempts.
Summary
- Without external backing, stability is only a function of growing demand.
- A twenty-percent yield with no nameable source is a subsidy.
- Algorithmic stablecoins with no collateral have failed multiple times.
Did you get it?
What is a death spiral in this context?
Support comes from issuing a second token, whose price falls as a result, requiring even more issuance.
Where did the high yield come from?
Mostly from a reserve set aside for it, meaning a subsidy of demand.
Which stablecoin types have external backing?
Collateralized ones backed by deposited assets, and overcollateralized ones backed by crypto collateral. Algorithmic ones with no backing don't.
Sources and further reading
- Public price data and protocol documentation from May 2022.
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