The collapse of Lehman Brothers was the largest corporate bankruptcy in U.S. history, accumulating $ 619 billion in debt. Lehmnan’s responsibilities were so enormous that it led to the Great Recession of 2008 – 2009, so it was necessary for the Federal Reserve to enter. At the same level of fallout is Terra’s fall for crypto space.
On the heels of Ethereum, with a $ 41 billion market cap in April, Terra (LUNA) is supposed to deliver Finance 2.0 by providing a blockchain counterpart to the VISA payment system. Additionally, one of its core dApps, the Anchor Protocol, attracts users with up to 19.5% yield on savings accounts.
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Unfortunately, Do Kwon’s Terra foundation relies on an algorithmic stablecoin TerraUSD (UST). Without real 1: 1 cash backing, UST kept its peg to the dollar through LUNA’s overcollateralization. When the bearish market lowered LUNA, Terra went into a death spiral, destroying $ 44 billion in wealth from May 5 to May 12.
Like the collapse of Lehman Brothers brought about by the Dodd-Frank Act, the lessons from the collapse of Terra will be lasting.
Table of contents show
1. Dead End for Algorithmic Stablecoins
2. The End of Suspiciously High Yield Staking
3. Lack of Accountability
4. Imposed Fiduciary Duty?
5. Final Thoughts
Dead End for Algorithmic Stablecoins
How can decentralized finance (DeFi) be truly decentralized by relying on stablecoins operated by corporations? For example, USD Coin (USDC) is operated by Circle and Coinbase. Each USDC stablecoin is backed by one dollar, which is regularly reviewed by an accredited accounting firm.
For this reason, if all USDC is suddenly redeemed, nothing will happen. That is, there will be no collapse spiral similar to a bank run. In contrast to these classic back-to-back stablecoins, algorithmic stablecoins must be self-managed and self-contained within the ecosystem.
In this way, they achieve decentralization by not relying on cash reserves. Instead, their peg to the dollar is collateralized by the network’s native token. In fact, due to the inherent volatility of low market cap cryptocurrencies, algorithmic stablecoins need to be overcollateralized. However, their history is full of failures in the operation of the bank:
- IRON stablecoin is collateralized by TITAN, native DeFi token for the Titan Finance lending protocol. Despite being supported by 75% from USDC and 25% from TITAN, the rapid withdrawal (bank run) of TITAN deposits caused its price to fall. In turn, IRON stablecoin has also dropped its peg to the dollar.
- Fantom’s fUSD stablecoin of 500% is overcollateral to the blockchain’s native FTM token. It has yet to reach the 1: 1 peg to the dollar despite Andre Cronje’s efforts.
- Basis Cash (BAC) has been announced as Do Kwon’s first algorithmic stablecoin project. Of course, it was also an abandoned failure like UST is today.
Now that Terra’s UST’s brutal wipeout has exposed the vulnerability of algorithmic stablecoins, investors are likely to avoid such projects. After all, Do Kwon’s new Terra 2.0 has no stablecoin. If anything, due to chronic inflation, we could see an increase in commodity-backed stablecoins, such as gold-backed Pax Gold (PAXG), Tether Gold (XAUT), DigixGlobal (DGX) and others.
It also means that full decentralization will have to sit in the back seat in favor of financial security.
The End of Suspicious High Yield Staking
Many people are unaware that stablecoins often yield the highest APY rates on more centralized platforms such as BlockFi. Although the national average interest rate for savings accounts is at 0.07%, it is nothing compared to the stablecoin yield.
Staking $ 1,000 on USDC stablecoin brings a higher yield than putting dollars in banks. Photo credit: DeFiRate.com
The question then is, why would a dollar-backed stablecoin like the USDC yield so much but the dollar itself so little? The simple reason is – higher demand than supply. While there are trillions of dollars, there are only billions of tokenized dollars. And their stability, especially when it is evaluated, is a valuable commodity.
So far, major market upheavals have partially destabilized the largest stablecoin by market cap, Tether (USDT) of $ 0.05 cents. However, the USDT quickly recovered by expanding its reserves.
More importantly, both stablecoin and cryptocurrency yields are market driven. Their collapse and decline depends on market performance. This is another thing that has been short-circuited by Kwon’s algorithmic UST stablecoin. Until the crash, Terra’s Anchor Protocol offered up to 19.5% yield rate for staked UST. The rate is artificially set to rapidly expand growth.
Rapid growth has indeed happened, as Terra is up from less than 1% of the DeFi market share in March 2021, to over 13% as of this May. However, because it is based on anti-market behavior it collapses faster. For example, the Anchor Protocol was artificially boosted by the Luna Foundation Guard (LFG) in February by $ 450 million.
That’s how the Anchor Protocol was able to pay for the high yield, even in the beginning. Turns out, not only is there nothing decentralized, but Terra artificially keeps the appearances to expand the bottom of its pyramid. Eventually, broader bearish market winds fell to the bottom despite the boosts.
The lesson? If one protocol offers double the staking yield than the other, something is happening, and it’s probably not a creative innovation but a pyramid scheme.
Lack of Accountability
Just as Ethereum has its own foundation, so does Terra with the Luna Foundation Guard (LFG). However, the latter appears to have used the veneer of decentralization as a command to act in the shadows.
LFG has 80k Bitcoin (~ $ 3.5b) at its disposal to defend UST’s peg, but there is little clarity on whether the money was used for this purpose. Dr. showed. Tom Robinson of Elliptic research that there is no way to positively determine whether BTC was sold or used to defend UST against de-pegging.
In the same way, the Terra validator releases have revealed disturbing practices on the part of Terraform Labs ’leadership. Terra’s mere opacity contradicts common trustee obligation practices. Regardless of the ongoing investigation by South Korean authorities, it is clear that DeFi’s projects need more transparency and investigation.
Otherwise, the spirit of decentralization will be abused only as a gimmick.
Imposed Fiduciary Duty?
To be protected from evil actors and experiments that are sure to fail, a balance must be struck between responsibility and innovation. In the immediate aftermath of the Terra collapse, Treasury Secretary Janet Yellen called for more federal regulation.
Of course, the $ 40B+ wipeout is nuts compared to the trillion in equities alone, but Yellen still sees the need to preemptively set the rules for digital assets.
“I wouldn’t describe them on this scale as a real threat to financial stability, but they are growing rapidly, and they present the same kind of risks that we have known for centuries associated with bank operations. “
Most recently, on Tuesday, Sen. Cynthia Lummis (R-WY) and Sen. Kirsten Gillibrand (D-NY) introduced a comprehensive crypto bill called the Responsible Financial Innovation Act. It will not only classify digital assets as commodities but it will legally define stablecoins as “indebtedness”.
Also, stablecoins will be issued by a deposit institution that needs to maintain high liquidity to back them up, ”at least 100 percent of the face value of
the responsibilities ”. This will go a long way in securing investor confidence. However, it must be kept in mind that CBDCs – digital currencies of the central bank – can cause skepticism throughout the stablecoin issue.
Without change, we won’t have talks about alternative currencies like Bitcoin, or revolutionary smart contracts that make banking services obsolete. However, by pushing the envelope, we must be careful not to lose sight of the main reason for such change to begin – financial liberation.
If it leads in the other direction, we are on the wrong path. Moreover, the algorithmic stablecoin story is not over yet. In the midst of Terra’s death, NEAR Protocol launched its USN. However, with all the lessons behind us, investors should regard such projects as risky experiments.
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Updated on Jun 13, 2022, 12:17 pm