Terra, 2022Needs one idea

A coin held at a dollar by an arbitrage against a second coin it could print. The mechanism that defended the peg was the mechanism that destroyed it.

3 min read · 564 words

What happened

• The design — a dollar-denominated token whose peg was maintained not by holding dollars but by an exchange mechanism with a companion token: one dollar of the stablecoin could always be swapped for one dollar's worth of the companion, and vice versa.
• The incentive — a large share of the stablecoin sat in a lending protocol advertising a high fixed yield, which is where much of the demand for holding it came from.
• May 2022 — the stablecoin traded below a dollar. Holders used the swap mechanism to exit, which minted new companion tokens.
• The spiral — the newly minted supply was sold, pushing the companion token's price down, which meant each subsequent redemption minted still more of it. Within days both the peg and the companion token had effectively collapsed.
• Afterwards — the episode is a reference point in supervisory work on stablecoins, and it separated in public what had often been described as one category into reserve-backed and algorithmic designs.

The mechanism

• Reflexivity is the whole story. The peg's defence depended on the companion token's value, and the companion token's value depended on confidence in the peg. Two things holding each other up is stable until it is not, and then it is fast.
• No external collateral means no floor. A reserve-backed token can be redeemed against something that exists outside the system. This one could only be redeemed against something the system created.
• A high advertised yield is a demand subsidy. Where the yield does not come from lending revenue, it comes from somewhere else — and demand that exists because of a subsidy leaves when the subsidy is doubted.
• The arbitrage worked exactly as designed. Nothing broke. Holders did precisely what the mechanism invited them to do, and the mechanism did precisely what it said it would.
• Settlement finality made it irreversible. There is no clearing house to unwind, no administrator, no reversal. Digital assets is the one market on this site where that is true by construction.

What it teaches

• Ask what backs the promise, in the worst state of the world. Not on an ordinary day — on the day everybody wants out at once. Anything that backs a promise with its own equity has no answer to that question.
• "Stablecoin" is a category with two unrelated designs in it. One holds assets; one holds a mechanism. Is a stablecoin actually stable takes the distinction apart.
• A yield is a description of risk before it is a description of income. The same lesson as the 2023 hybrid write-down, in a market with no regulator to appeal to.
• Feedback loops are visible in advance. The question "what does this mechanism do if the price falls" was answerable from the documentation, before it was answered by events.

The mechanisms behind this

• Stablecoins — the instrument, and the two designs.
• Digital assets — the market, and what settlement finality means there.
• How products fail — the feedback-loop pattern, across instruments.
• FTX, 2022 — the other half of that year, and a different failure entirely.