On the 26th of May, Vitalik Buterin shared an article that expatiated on the architecture of algorithmic stablecoins. The Ethereum billionaire shared the article with his 3.9 million Twitter users.
The article broke down the architecture of Terra’s UST and LUNA while comparing the token to RAI, a more reliable stablecoin. Also, prominent crypto figures like Dan Robinson, Hayden Adams, and Dankrad Feist were acknowledged for their contributions to the experiment.
Why Stablecoins Should Not Rely on an Endless Crypto
Terra’s UST and LUNA have failed woefully in the past month. The algorithmic stablecoin relied on the price of LUNA to maintain its stability. Unfortunately, the loopholes in this stability mechanism were uncovered by the recent market volatility.
The research paper broke down the flaws. The UST stablecoin had a price to maintain, which was $1. When UST trades above the $1 peg, the protocol auctions off new UST, and burns LUNA until the price return to its target. At the same time, when UST trades below $1, the protocol buys back and burns UST, while minting LUNA tokens to fund the burn.
The major flaw in this stability architecture is that it solely relies on favorable market conditions to run. LUNA’s price is associated with the expectations of fees from future transactions in the protocol. So when expected future activity on the protocol dropped, Luna’s market cap also plummeted significantly. The system became fragile and a slight decline in UST led to the minting of millions of LUNA. The hyperinflation of LUNA caused panic among holders, making UST to further lose its value.
The experiment further revealed why the 20% interest rate for UST was unsustainable. One way this could be sustained was by rewarding users of the protocol with funds from other investors. Interestingly, RAI which is also a collateralized stable has a 4% annual return. However, this APY is more realistic and is sustained by a negative interest rate. This means that the protocol has a floating target that drops when the redemption rate is negative.
Obviously, Terra’s crash proves that frameworks that rely solely on the stability of the crypto market are unsustainable.
