At a Mexican restaurant in North London a few weeks ago, a handful of small-time but remarkably discerning retail cryptocurrency investors predicted that terra and luna would crash. Several of them were scoffing at terra, or UST, a stablecoin whose price equivalence to the dollar is underpinned by algorithms and game theory rather than cash or collateral, and at the notion that it would maintain its peg in the long run.
The “Ponzinomics†of the project, they informed me, were just too risky. Only one of the investors seemed optimistic, out of nihilism rather than trust in terra’s solidity. He said that at some point UST’s price would grow well above one dollar per unit, and the coin’s promoters would decide to just keep it there and rebrand the stablecoin as an “inflation-resistant cryptocurrency dollar.†Another shrugged but conceded that all bets were off. “So far,†he said, “this story has always followed the most humorous timeline.â€
You can bet a lot of people do not feel like laughing today. UST has lost its peg to the dollar (at the time of writing, you can buy it on cryptocurrency exchanges for $0.58), and its sister asset luna has plummeted from $82 last week to $0.02. A big chunk of the investment of around $60 billion in these cryptocurrencies was pulverized overnight, and more of it will follow as people scramble to get rid of their diminished coins.
Meanwhile this week, the wider crypto market is in turmoil as bitcoin fell to $27,000 after bleeding 8 percent of its value in 24 hours, and many other cryptocurrencies are trailing its descent. Tether, the world’s largest stablecoin, dropped under $1 on Thursday.
With terra, we are witnessing the crumbling of a project predicated on the notion that you can create money—and assign it a specific value—if people are willing to go along with the pretense that money has the value that crypto companies assign it, akin to role-playing in a video game.
A small subsection of hardline crypto believers would retort that in the age of post-gold-standard fiat money, most currencies are indeed just a collective delusion. But the fact that there is no government, central bank, economy, or actual usage underpinning terra matters. As Frank Muci, a policy fellow at the London School of Economics’ Growth Lab Research Collaboration, puts it, “It is similar to a bank run, except it's a run on nothing.â€
UST was marketed to the public as a stablecoin, a type of cryptocurrency whose value supposedly remains steady over time, creating a convenient hedge against the wild price fluctuations of other cryptocurrencies like bitcoin or ether. With most stablecoins, that stability is guaranteed by currency reserves—whoever creates a stablecoin pegged against the dollar should theoretically keep an equivalent amount of dollars in a vault somewhere—or other collateral, including crypto. Except UST is an “algorithmic stablecoin†and has none of that. It is fully shielded from the real world, and takes pride in it.
On Terra’s own blockchain, UST has a symbiotic relationship with its satellite asset luna, which can be used to earn cryptocurrency rewards. It was always possible to exchange UST for luna and vice versa, and the blockchain’s own code always made sure that terra traded at a dollar a unit, while luna’s varying price was determined by algorithms keeping an eye on the market.
That was supposed to keep its price stable by piggybacking on the work of arbitragers, investors who attempt to profit from market inefficiencies. If a sell-off of UST on cryptocurrency exchanges threatened to lower its price below $1, the idea was that smart arbitragers would rush to buy UST, and use them on its native blockchain to buy luna at a discount—propping up UST’s price in the process.
If the opposite happened and UST’s price zoomed over $1 on crypto marketplaces, people would use their lunas to buy one-dollar-a-unit USTs on Terra’s blockchain and resell them on other platforms, bringing the price of UST down. It is a clever architecture. It is also one that did not and could not work. “It is a bit like perpetual motion machines. People wanted to figure out how to get free energy. And these designs were complicated—they would have pulleys, they would have magnets, they would have levers,†Muci says. “With algorithmic stable coins, it's a little bit the same idea.â€
Ryan Clements, an assistant professor in business law and regulation at the University of Calgary, made the issues with this approach clear last year, in a paper devoted to algorithmic stablecoins titled “Built to Fail.†One of the main problems with these stablecoins, Clements explained in the paper, is that they can only work so long as there is demand for them; otherwise all those incentives mean nothing. “UST was never stable to begin with and was never fully collateralized,†Clements says. “It required a perpetual reliance on an assumption that there would be enough (ongoing) interest in the various use cases of UST in the Terra ecosystem.â€
Many crypto investors started finding their way to the door. Bobby Ong, cofounder of cryptocurrency analytics platform CoinGecko, says that one possible explanation for what happened to UST is “a George Soros-style†attack, after the Hungarian philanthropist and financier’s famous bet against the British pound in 1992. According to this theory, UST’s ruinous fall—which started on Monday and spiraled into a catastrophe on Wednesday—was precipitated by a large entity dumping billions of UST on the market, shattering its peg. Another, simpler explanation is that UST was just not sustainable, and this was always going to happen as soon as the market's sentiment changed.
It is telling that some crypto personalities are laying the blame for the supposed attack at the door of investment management company BlackRock and hedge fund Citadel. Just over a year ago, Citadel had already been cast as the villain in another financial craze, the so-called GameStop saga—when millions of retail investors started buying the stock of the ailing game store chain in droves, despite its dubious fundamentals, in an odd act of defiance against traditional finance. Several observers back then had saluted the rise of meme finance, where the value of assets was no longer based on a business’s prospects and instead determined by collective delusions, performative contrarianism, and sheer nihilism (“Is [GameStop’s stock] worth 200+ dollars? That's for you to decide based on your own value system,†one investor commented on Reddit, where the rebellion first emerged.)
Terra’s rise and fall is, in a way, the endgame of that long stretch of weird finance. It might not recover, and instead follow in the wake of other Web3 downturns, such as the bursting of the NFT bubble or the fall of a great deal of meme stocks and dog coins.
But it would be disingenuous to read all this through the lens of absurdism and pipe dreams. Terra’s explosion in popularity over the past six months was also driven by mind-boggling incentive schemes. “The large demand for UST was driven because of a savings protocol called Anchor on Terra’s blockchain, which promised 20 percent in annual percentage yield,†Ong says. People would buy UST and stash it in Anchor, a piece of software where one could park one’s coins, hoping to see it grow like a magic money tree over time. What’s more worrying, Ong says, is that Terra set an example for many other crypto projects, which also started promising absurd returns and now are at serious risk of crashing.
The Ponzinomics were just too obvious: When you pay money for nothing, and stash your nothing in a protocol with the expectation that it will give you a 20 percent yield—all you end up with is 20 percent of nothing.
