Depegging: A History Lesson - Part 2
In which the ride is even bumpier.
Stable Sis
1/11/20264 min read
This is part 2 of the story of Terra. If you have not already, I would strongly suggest reading Part 1 first, otherwise things will sound even stranger than they actually were.
Ready? Let's dive back in.
It's time to introduce another protocol in the Terra ecosystem, Anchor. Shortly after the launch of UST, a deposit and borrowing scheme was introduced by Do Kwon. Just like with the launch of UST itself, the purpose was to increase activity on the Terra network. UST holders could deposit their coins on Anchor and earn a nice 20% yield. If, on the other hand, they wanted to borrow some UST, they could also do that on Anchor and get an interest rate anywhere between 2% and 15%, provided they could post enough collateral.
If your eyebrows are already raised then you know where I'm going. If they're not, it's fine, come along and I'll show you why this is a house of card waiting for a gust of wind.
Traditional banks lend at much higher rates than they pay on their deposits, if they pay any interest on their deposit at all. If they pay a 2% interest rate on deposit, they then charge a 10% to lend money out. So, if you deposit 100 Euros, they will pay you 2 Euros. They will then lend those 100 Euros and pocket 10 Euros in interest, netting 8 Euros. And this is ignoring the magic money creation effect which is at the basis of the financial system. You can see why banking is a profitable business.
Anchor however, could only become profitable under one very specific condition: massive amounts of borrowing. Under this condition, borrowers would post enough collateral, which would then earn the staking reward for Anchor, which would in turn be used to pay the yield on the deposit. For this to work, the amount borrowed should of course by far exceed the amount deposited. Not unlike what happens in the traditional financial system
I mentioned in the previous post that Do Kwon's aspiration was building an entire economy around Terra, so that UST would acquire intrinsic value even without any collateral backing it up. Once he set up Anchor however, what ended up happening was the equivalent of everyone keeping all their money in one bank that pays a high interest rate on deposits and never investing it or spending. That does not make much of an economy. So once Anchor decided to lower its yield to 18% and implement a programme to keep reducing the interest rate it paid on deposits investors simply left. Some large positions were unwound and, with the information being immediately available on the blockchain, everyone rushed for the door. Actually what happened is that people split in two camps: those that made a swift exit and gained a handsome profit and those who stayed, tried to buy the dip and ended up shouldering immense losses.
We all know what happened next, Do Kwon was charged, found guilty, fined ultimately sentenced to 15 years in prison. Daniel Shin (Terra's co-founder) is currently awaiting trial. Jump Trading is facing a 4 billion lawsuit. Sam Bankman-Fried's Alameda research was also investigated in relationship to the collapse of Terra and the role it might have had triggering its downfall. No charges were ever filed, for obvious reasons I would assume.
Where does that leave us?
Nowadays regulations are pretty clear that algorithmic cryptocurrencies are not covered by their provisions, so anyone engaging with them will do so without any of the protection enjoyed by the other kinds of stablecoins. One simple solution could be to simply stay clear. Is there however, something we can learn about risk management when it comes to regulated stablecoins?
The first lesson is have your IT infrastructure in order. It may seem obvious, but it bears repeating. In the May 2021 depegging crisis, Terra was hit by a large sale and at the same time by its infrastructure being taken down. Luckily in the EU, DORA compliance is mandatory for all stablecoin issuers. Rather than thinking of it as another annoying compliance exercise, it pays to think of it as the essential safety infrastructure you need for your survival.
The second is that in a world where everyone can see where the trades are coming from and going to, as it is the case with the blockchain, the changes are really large and really fast. You may have taken a macroeconomic class in which, as a thought, experiment, you discussed what would happen if everyone had perfect information. At the time, it would have seemed obvious and yet somehow far-fetched that price would adjust instantly. Well, that world is there now. Stock exchanges have built in handbrakes that can be pulled when stock prices fall too much. The same mechanism should be applied to stablecoins. I would argue however, that it needs to be faster and stricter. If you want your stablecoin to remain stable, then stop the volatility, even if that means using a blunt instrument. Finesse can come later, once we have all learned how this works.
The final lesson is that bad actors with deep pockets can do a lot of damage, and can do so quickly. The identity of the actor(s) triggering all the depegging events is unknown. They could be rational investors simply doing what was in their best economic interest (here and here). They could also be bad actors intent on sabotaging Terra (here and here). For issuers this means know your customers, know your customers and again, know your customers. Sacrifice some of the in-built privacy offered by the blockchain for the sake of the safety of the entire infrastructure. As much as possible, know who is building large wallets of your coin. For holders of stablecoins, that means look at the wallets and assess the concentration of the chain. Ask yourself how much damage could be done by unwinding the single largest wallet, the five largest wallets and the 10 largest wallets.
If you would like to read more about this, I highly recommend this paper by Russell Wong at the Federal Reserve Bank of Richmond.
Until next time,
Stable Sis