Stablecoin: how the promising Terra collapsed on itself in 24 hours

On Twitter, there are countless messages from investors ruined by the stablecoin TerraUSD and its “sister” cryptocurrency, Terra (also known as Luna, its ticker on the markets). The scandal, which erupted earlier this week, further undermines investor confidence amid the rout of the crypto market.

Terra which was still, at the beginning of 2022, the 9th crypto with a capitalization of more than 30 billion dollars, literally collapsed. On Thursday, it sank 99.8% and sank to 173rd place in the cryptocurrency ranking. On the Reddit forum threads devoted to Terra, the administrators had pinned suicide prevention numbers…

What happened ? The drop in cryptos, against the backdrop of the telescoping of the bitcoin bubbles (-30% over 30 days) and the Nasdaq (-15%), is certainly severe. But it does not, on its own, explain this collapse. The panic actually comes from the decoupling between the TerraUSD and the dollar. Stablecoins are meant to be stable digital currencies. TerraUSD was to guarantee a 1 to 1 parity with the US dollar. However, on Thursday morning, it was only worth half of it. And as soon as the TerraUSD got too far away from the dollar, investors totally lost confidence.

An impossible parity

Most major stablecoins like USDT and USDC are backed by the dollar. For each crypto issued, in theory, an equivalent amount is purchased in US treasury bonds and placed in a reserve account. TerraUSD, for its part, is an algorithmic stablecoin. Maintaining its parity with the dollar relies on computer processes managing the link between the two cryptos, TerraUSD and Terra. A solution that has so far not been proven, but that the founders of the stablecoin thought they had really improved.

The problem is that, caught in the crypto market storm, the Terra stalled. Its value has fallen so much that the arbitrage mechanisms no longer allow it to support the TerraUSD. To protect parity, the Luna Foundation Guard liquidated $1.5 billion in bitcoin, but that wasn’t enough to push TerraUSD up enough.

Over the same week, while TerraUSD lost 42%, its true dollar-backed competitors weathered the turbulence better: USDT was not budged an iota over the period, at $0.99 and USDC took 0.15% to 1 dollar. From then on, “the usefulness of the TerraUSD protocol lost its meaning”, notes Vincent Pellizzari, consultant at CoinsPaid. It collapsed like a house of cards.

The rumor of a raid

On social networks, speculation is rife about this express crash. The founder of the Cardano blockchain, Charles Hoskinson, even for a time advanced the hypothesis of a raid by BlackRock and Citadel, before deleting his tweet. The funds have both denied this thesis in press releases. Others, like the analyst Onchain Wizzard, evoke a 1 billion operation on the TerraUST.

One thing is certain, according to Vincent Pellizzari, “like in the financial markets, if there is an opportunity for an attack, it will happen because the markets are free, especially in cryptos”. Janet Yellen, the American Secretary of the Treasury, was quick to come out of the woodwork to recall that this episode “simply illustrates the fact that it is a rapidly growing product, that it presents risks for the financial stability and that we need an adequate framework”.

At the end of last year, the IMF warned that many stablecoins did not provide enough information on their reserves. “There is a need for improvement to align with the standards of monetary funds”, underlined the international organization. The risk ? That some stablecoins are experiencing a “bank rush” (a run) like during banking crises, as stablecoin holders seek, en masse, to liquidate their assets and recoup dollars in exchange. The companies that issued these assets would then not be able to honor their commitments.

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