The Death of (Terra) a Stablecoin

12 thg 5, 2022

An algorithmic stablecoin sounds complicated, but that doesn't have to be.
That's how Terra envisioned its algorithmic stablecoin and why it inevitably crashed.
Here's how stablecoin Terra & Luna work:

1. In 2018, Terra network was created with two native tokens. Let's call them Terra (UST) and Luna (LUNA), of which the reasons will become apparent later on.

2. Terra is the stablecoin of the two and Luna has a variable price. These tokens are nothing more than numbers and a protocol on the blockchain.

3. For the ecosystem to work, we need to find people who want to buy these tokens, we do marketing.

4. Luna's price can vary, and is determined by the good old concept of supply and demand. Luna's price will be right in the middle.

5. If people find Luna fantastic, the demand for Luna goes up and so the price goes up, or at least not to zero.

6. Now here come's the tricky part: the blockchain promises that people can always exchange One Terra for $1 worth of Luna.
That means if Luna is trading at $0.5 you get 2 Luna for One Terra. When Luna is trading at $4 you get 0.25 Luna for One Terra.
If Luna trades at $10 you get 0.1 Luna and so on. The price of Luna can vary, but One Terra can always be exchanged for $1 worth of Luna.
The reverse is also true and possible, people can always exchange $1 worth of Luna for One Terra.

7. Now we make an automated smart contract to make this exchange possible. Et Voila, stablecoin Terra is created.

8. Terra should always be worth $1. So terra should always trade at $1. If Terra trades above $1, arbitrage traders will buy Luna and then sell Luna for Terra for instant profit.
If Terra trades below $1, arbitrage traders will buy discounted Terra and exchange it for Luna for instant profit. Arbitrage traders will push the price of Terra back to $1 if it deviates.

9. Luna's price can fluctuate but that doesn't matter. As long as Luna is not zero, you can exchange Terra for $1 worth of Luna and Luna for around $1 of Terra.

Now we need to make sure Luna doesn't go to zero, since that would turn out very bad. So we need to give fundamental value to Luna, these are the ways to do this:
- Collect transaction fees from people who exchange Luna for Terra & Terra for Luna and distribute (a part of) these fees to Luna holders as interest.
- Create an ecosystem of smart contracts and applications on top of Luna and terra in which Luna is treated as the native currency to use this ecosystem. And ascribe a lot of value to it.

This reinforces each other pretty well.
The more fees you collect and distribute to Luna holders, the more viable your ecosystem gets. The more applications are being being built, the more Luna is being bought to interact in the ecosytem & the more fees are collected.

But besides this, there's no algorithm explicitly saying that Luna always has a particular amount of value. The algorithm just lets people exchange Terra for Luna. Luna is only valuable if people think it’s valuable and believe in the long-term value of the system that you are building.

The danger arises when people suddenly turn their back on Luna and think "Wait, it's all useless and it isn't real." and all sell their Luna tokens for Terra, which should always be equivalent to $1.
If people sell their Luna, the price of Luna goes down.
If people sell their Terra, you might think "the price of Terra can't go down because of the algorithm!". So if Terra drops to $0.97, arbitrage traders would buy it and exchange it to $1 worth of Luna for instant profit.

Well. The problem is that when people lose trust in the whole system, they will dump both Luna and Terra. It looks like this:
- Someone sells their Terra, and Terra drops to $.97
- An arbitrage trader buys 10 discounted Terra and exchanges it for Luna. Luna trades at $40 so the trader gets 0.25 Luna. (because exchange of Luna is at $1 par.)
- Then the arbitrage trader sells their Luna, which drops the price of Luna to $20.
- A second person sells their Terra, and Terra drops to $0.97.
- An arbitrage traders buys 10 discounted Terra and exchanges it for Luna. Luna trades at $20 and the traders gets 0.5 Luna.
- Which the arbitrage traders sells again, making the price of Luna drop even further.
- Now Luna is worth $10, so 10 Terra gets you 1 Luna, which then gets sold, so Luna goes to $5, so 10 Terra gets you 2 Luna, etc.

There's no stopping this process, it's a death spiral going down fast. Eventually Luna trades at $.01 and 10 Terra gives you 1000 Luna. And when you try to sell your Luna, you can't, because there are no buyers left and there are no arbitrage traders left who buy discounted Terra to exchange for Luna.

The founders are actively searching for a solution, one is looking for capital of investors and the other is to mint way more Luna, so that One Terra can reliably be exchanged for $1 worth in Luna. Even if that means bazillions of Luna.

Thanks for taking the time to read this idea. Stay safe out there. Support by following and sharing!