Terra is crumbling.
The blockchain project that houses popular algorithmic stablecoin TerraUSD (UST), which had recently become the fourth-largest stablecoin by market value but is now fifth, is on the verge of collapse as UST repeats its $1 Binding and LUNA, home of blockchain, not maintaining tokens, is approaching zero.
Terraform Labs, the tech start-up behind the development of Terra, stopped producing new blocks on the network on Thursday “to prevent governance attacks after severe $LUNA inflation and significantly reduced attack costs,” it said Twitter.
A governance attack became cheaper due to LUNA’s near-free price – an attacker could buy enough LUNA tokens cheaply to socially attack the network by forcing a majority decision. (Since Terra relies on a proof-of-stake (PoS) derivation for consensus, rather than hardware and electricity, as in bitcoin’s proof-of-work (PoW), coin ownership equals power. In bitcoin, quantity equals BTC that you own does not grant you more power on the network.)
The network went live a few hours later when the software patch was released.
This is another key difference between a network like Terra and Bitcoin: while in the former a minority of entities can vote on things like pausing the network, Bitcoin’s true decentralization makes it immune to the whims of a particular group.
How does VAT work?
Stablecoins are digital representations of value in the form of tokens that attempt to maintain one-to-one parity with a fiat currency like the US dollar. Tether (USDT) and USD Coin (USDC) top the market cap rankings and are the most popular and widely used stablecoins. However, they are issued (minted) and destroyed (burned) by centralized entities, which also maintain the necessary dollar equivalent reserves to back the coin.
Terras UST, on the other hand, wanted to become a stablecoin whose minting and burning process was done programmatically by a computer program – an algorithmic process.
Under the hood, Terra “promises” that people can trade 1 UST for $1 worth of LUNA (the value of which fluctuates freely based on supply and demand) at any time. If UST breaks its peg to the upside, arbitrageurs can trade $1 worth of LUNA for 1 UST and take advantage of the premium with an instant profit. If it breaks the peg to the downside, traders can exchange 1 UST for $1 worth of LUNA, also for an instant profit.
What does bitcoin have to do with it?
Terra rose to prominence in the bitcoin community after Terraform Labs founder Do Kwon said earlier this year that the project would acquire up to $10 billion worth of bitcoin for UST’s reserves.
The purchases would be made and coordinated by the Luna Foundation Guard (LFG), a Singapore-based non-profit organization working to drive demand for Terra’s stablecoins and “support the stability of the UST peg and support the growth of the Terra- promote ecosystems”.
While allocations of corporate finances to Bitcoin have grown in popularity over the past few years following MicroStrategy’s continued BTC purchases, LFG’s move represented the first major allocation of BTC as a reserve investment by a cryptocurrency project. The news was met with a mixed bag from the community out of enthusiasm and skepticism.
Bitcoin Magazine reported at the time that the algorithmic maneuver used by the UST stablecoin to maintain its peg was of dubious sustainability and the bitcoin purchases did not make UST a stablecoin backed by bitcoin. Even Terraform Labs acknowledged that “questions still remain about the sustainability of algorithmic stablecoin pegs.”
Terraform Labs also discussed how there needs to be sufficient demand for Terra stablecoins in the broader cryptocurrency ecosystem to “absorb the short-term volatility of speculative market cycles” and guarantee a better chance of long-term success. This is exactly what the project with BTC wanted to achieve – create demand for UST by creating more confidence in the sustainability of pegs.
How did Terra implode?
Given the many unanswered questions about the sustainability of such an algorithmically supported peg, Terra’s design could not hold up during a stressful phase.
As a result, as UST began to lose its peg to the downside, additional pressure was placed on LUNA as the massive amount of UST increasingly attempted to exit and switch
As UST began to lose its peg to the bottom, traders attempted to exit by redeeming each of their UST for $1 worth of LUNA. However, given the rapid pace of depreciation, a huge amount of UST attempted to exit – more than what Terra could trade for LUNA. That widened the on-chain swap spread to 40% and put additional pressure on LUNA, sending its price strongly south.
The token then fell by a “death spiral.”
UST has been struggling to maintain its peg to the US dollar since Monday. Image source: TradingView.
In a ripple effect, LUNA crashed, falling near zero on Thursday. Image source: TradingView.
What does this teach us?
In summary, it can be argued that the lesson learned is that alternative cryptocurrency projects (altcoins) are just an experiment, while Bitcoin is the only tried and tested peer-to-peer digital money.
Bitcoin was born out of the ideals of the Cypherpunks, a group of early cryptographers with a shared vision who came together to explore what privacy could mean in the then-nascent digital world – particularly when it came to money.
The cypherpunk movement grew largely out of the work of Dr. David Chaum, a cryptographic pioneer who brought mathematical technology out of the hands of government bureaucrats and into the realm of public knowledge. His explorations sparked a body of work devoted to how society might transfer peer-to-peer money – cash – into a digitized economy.
With a clear goal in mind, these mathematicians began to work out what a solution might look like through research and experimentation. Decades later, Satoshi Nakamoto put it all together and added his own spin to arrive at Bitcoin, the first and only decentralized and trusted form of digital money.
As bitcoin grew in popularity, alternative forms of what became known as cryptocurrency – a currency that exists in the digital realm through the use of cryptography – began to be created. While these coins were originally born to compete with Bitcoin, a whole host of new projects later emerged with different value propositions while putting their own spin on the blockchain, consensus, and cryptography that made Bitcoin work.
Nakamoto designed the Bitcoin protocol to use PoW, a consensus mechanism that relies on computational power and free competition, to mint new BTC on Bitcoin’s blockchain. The bitcoin mining race as it is known consists of thousands of miners scattered around the world with a single goal – to find the next valid block and get bitcoin as a reward.
However, altcoins have largely moved away from PoW in favor of other novel consensus mechanisms. The most popular alternative, PoS, allows participants to lock their holdings of each project’s native token to become block creators, rather than having them compete with mining hardware and electricity to mine new coins.
While PoW has a real cost to miners, the cost in PoS is purely digital and represents the amount of money spent to buy those coins. The assumption at PoS is that staking these coins ensures miners have a role in the game and are therefore encouraged to behave honestly, but there is no evidence that such engagement is a sufficient incentive. Additionally, in cases where strong debasement occurs, as with LUNA, there is a risk that the network will be hit by a governance attack and will have to take totalitarian measures, such as halting block production of a supposedly permissionless and unstoppable decentralized network.
PoW-PoS dynamics are also important because they highlight the experimental nature of altcoins.
Instead of copying the Bitcoin model – a strategy that has consistently proven unsuccessful – new altcoin projects are trying to “innovate” by copying some parts of Bitcoin’s design and changing others.
As a result, projects launched today move away from most of the ideals that underpinned the cypherpunk movement that began decades ago. Such projects call themselves decentralized, but mostly have a founding team that hardly loses its control position and can control every decision that happens in the network.
With such a strong desire to innovate, “crypto” projects mostly create artificial problems that don’t exist so they can invent a novel solution.
dr Chaum and the Cypherpunks have recognized a clear problem in society: In the digital age, how will we have money that cannot be spent twice without a central authority keeping track of the balances? It took many specialized scientists and mathematicians from different backgrounds decades of research to finally arrive at an elegant solution to this problem.
Today, however, cryptocurrency teams only take a few years from ideation to a minimally viable product and do not enjoy organic growth in favor of huge amounts of capital that disproportionately favors insiders at the expense of the regular user.