a resounding failure for algorithmic stack coins

Terra was without a doubt one of the most ambitious stablecoin protocols in the cryptosphere, arguably too ambitious, some would say in light of recent events. While the future of blockchain remains unclear, most players in the cryptosphere say, after a waltz of interruptions and then resumes of blockchain operations, that they are disappointed with the way this affair has been handled.

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The CEO of Binance, Changpeng Zhaoalso expressed its annoyance … which did not prevent the stock market from resuming spot trading operations for Luna and UST after removing the two tokens.

While we wait to be fixed on Terra’s fate, here’s a return on the circumstances surrounding the disaster, to draw some experience and determine if future projects with algorithmic stack coins still have a chance to break through and survive.

Brief reminder of how algorithmic stack coins work

The parity of the very first generation of stablecoins entering the market, such as Tether (USDT) or USDCs Circle, was guaranteed by real assets: banknotes, commercial bonds, bonds … On the other hand, algorithmic stack coins are considered unsecured and have no associated guarantees. The algorithm or protocol that supports them acts as a central bank. The rules that define the operation of the algorithm are defined in a smart contract and can only be changed by relying on social consensus or by governing votes associated with the corresponding tokens.

In Terra’s ecosystem, the dollar-backed stablecoin UST uses a slightly different setup thanks to another token, LUNA, to maintain its point. Instead of being supported by a 1: 1 ratio of tangible assets in a bank or depository, the creation (“coin”) of a UST token requires the destruction (“burning”) of a LUNA token. The mechanism allows for the use of an arbitrage option, which in theory should keep the price of LUNA stable.

This mechanism failed when the UST price fell below its $ 1 bond value, leading to a massive amount of arbitrage trading, with traders burning USTs for $ 1 by Luna, which were then sold at a profit. However, the continued sale of Luna caused its value to fall, not only canceling the arbitrage option, but increasing the volume of Luna in circulation as the price continued to fall.

There are allegations that an unknown player flooded the UST market to attack the protocol, and another took a very public $ 10 million short position against the asset. However, the alleged perpetrators denied any involvement.

A flawed system from the start?

The algorithmic stablecoin system looks ingenious on paper, but is far from proven. In fact, many attempts to create an algorithmic stablecoin have failed in the past. Neutrino, a blockchain-based stablecoin waves, compared to Ethereum, ended up in the same unfortunate circumstances as Terra. Last year, one of the bugs that was remembered was the bug in the DeFi protocol IronFinanceif stablecoin TITAN fell to zero, an event that the project team had called “the first crypto bank to be run globally.”

Luna no doubt sought to learn from these many failures and allay some buyers’ concerns about the token’s underlying value by announcing a $ 10 billion acquisition of Bitcoin to strengthen its reserves and protocol stabilization mechanism. Shortly before the loss of UST’s anchorage, Luna Foundation Guard had already bought Bitcoin and Avalanche (AVAX) for more than $ 3 billion. But using a single asset whose price is extremely volatile to support reserves was probably not the best option. One of the possible alternatives was to use a portfolio of assets that was as diversified as possible.

Moreover, algorithmic stack coins are inherently volatile assets: yes, according to the publication West Forrest Law Review, any algorithmic stablecoin needs a minimum demand threshold, making it an inherently fragile product. In particular, the token that serves as security must maintain a constant and increasing level of demand, because otherwise the whole ecosystem will fail. In addition, these stablecoins rely on arbitrageurs, independent players, who are not obligated to intervene to take advantage of profit opportunities and maintain price stability through buybacks or sales. It should also be noted that in periods of volatility, panic and crisis, the information circulating, especially at the level of price oracles, is often opaque. Price uncertainty for the TITAN token, due to delays in an automated “oracle” source of information, contributed to the bankruptcy of Iron Finance.

It was all predictable, as summed up Sam Bankman-FriedCEO of FTX in this tweet:

Do Kwon, a controversial figure in the crosshairs

All heads are now turned to the brains behind the protocol, Make Kwon. His rise will have been as spectacular as his fall and has brought far less brilliant aspects of his personality to light. Coindesk went on to compare the director of the infantry with Elizabeth Holmesthe founder of the biotech empire Theranos, convicted of fraud and conspiracy. According to the article, Kwon repeatedly displayed arrogance and contempt that should have made investors think twice. His inability admitting the weaknesses of the protocol in a thread posted on Twitter is one of many red flags that many have chosen to ignore.

Significant side damage

Unfortunately, the damage caused by Luna’s fall is not limited to Terra and its DeFi protocols (including Anchor Protocol, Astroport, and Mars Protocol), but has spread to the ecosystems Cosmos, Avalanche, and all stack coins. . Additionally, when LFG flooded the bitcoins market to protect price fixing, sales pressure built up, driving the price of the cryptocurrency to below $ 30,000 for the first time since July last year.

This infernal spiral has apparently attracted the attention of regulators and reinforced the already well-established sense of distrust of stack coins. In his latest report Federal Reserve said the three assets with the greatest financing risk were certain money market funds, certain bond funds and stack coins. The latter sector, according to the report, “remains exposed to liquidity risks” and “vulnerable to outcomes”.

We can take from this debacle that one of the key points is that public and investor confidence in a protocol is one of the most important elements for its survival, which brings us to two key principles for stablecoins. The first is collateral, which must be accompanied by a third-party periodic review of reserves to give users confidence that the asset will retain its value. The second is decentralization so that everyone can monitor the level of reserves on the chain in real time and verify that the protocol is solvent. When it comes to Terra, trust in the protocol appears to have been permanently eroded, and Do Kwon is working to salvage what he can, with a redistribution plan to compensate network debtors and loyal members of the community.

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