The collapse of the TerraUSD stablecoin
The implosion of TerraUSD (UST) highlights inherent fragilities in some versions of stablecoins. The use of UST
grew rapidly over 2021–22 so that, prior to its collapse, it was the third largest stablecoin, with a peak market
capitalisation of $18.7 billion. An algorithmic stablecoin, it maintained value by adjusting supply in an
automated arbitrage trading strategy with another cryptocurrency, Luna, on the Terra blockchain. UST aimed
to keep a one-for-one peg to the US dollar by being convertible into one dollar’s worth of Luna, and vice
versa. For example, should Terra fall to 99 cents, a user could purchase UST on an exchange for 99 cents and
then exchange their UST for $1 worth of new units of Luna on the Terra platform. A crucial aspect of this
arrangement was that users would only be willing to exchange UST into Luna if Luna’s market capitalisation
exceeded that of UST. As Luna had no intrinsic value,
its valuation stemmed primarily from the influx of
speculative users into the Terra ecosystem. To attract new users, the associated lending protocol Anchor
offered a deposit rate of around 20% on UST. As long as users had confidence in the stable value of UST and
sustained market capitalisation of Luna, the system could be sustained. The Terra/Luna pairing was regarded
as being especially significant as it promised to offer a “self-levitating” version of money that did not piggyback
on real-world collateral assets Structural limitations of crypto
In addition to the immediate concerns around stability, crypto suffers from the
inherent limitations of permissionless blockchains, which lead inevitably to the
system’s fragmentation, accompanied by congestion and high fees.
11 Tracing the
reasons for fragmentation is revealing, as these highlight that the limitations are
not technological but rather stem from the system’s incentive structure.
Self-interested validators are responsible for recording transactions on the
blockchain. However, in the pseudo-anonymous crypto system, they have no
reputation at stake and cannot be held accountable under the law. Instead, they
must be incentivised through monetary rewards that are high enough to sustain
the system of decentralised consensus. Honest validation must yield higher returns
than the potential gains from cheating. Should rewards fall too low, individual
validators would have an incentive to cheat and steal funds. The consensus
mechanism would fail, jeopardising overall security.
The only way to channel rewards to validators, thus maintaining incentives, is
to limit the capacity of the blockchain, thus keeping fees high, sustained by
congestion. As validators can choose which transactions are validated and
processed, periods of congestion see users offering higher fees to have their
transactions processed faster (Graph 2.A).12
The limited scale of blockchains is a manifestation of the so-called scalability
trilemma. By their nature, permissionless blockchains can achieve only two of three
properties, namely scalability, security or decentralisation (Graph 3). Security is
enhanced through incentives and decentralisation, but sustaining incentives via fees
entails congestion, which limits scalability. Thus, there is a mutual incompatibility
between these three key attributes, preventing blockchains from adequately serving
the public interest.
