Terra starts the "death spiral", how to save itself under the gamble?

"Algorithmic stablecoin" (algorithmic stablecoin) sounds complicated, and there are many people who have an incentive to pretend to be complicated, but it is not. Here is how algorithmic stablecoins work:

1. You wake up one morning and invent two cryptographic tokens.
2. One of these is a stablecoin, which I named " Terra ", for self-evident reasons.
3. The other is not a stablecoin. I named it " Luna ".
4. To be clear, they are all just things you made up, just numbers on the ledger. (The ledger might be maintained on a decentralized blockchain, although you could theoretically maintain it on your computer with Excel.)
5. You try to find people who buy them.
6. The transaction price of Luna will be determined by supply and demand . If you just made it up on your computer, saved it in Excel, and laughed and told other people about it, it would cost zero, and none of that would work.
7. But if you do a good job marketing Luna, its price will not be zero. If its price is not zero, then you are in business.
8. You promise that people can exchange a Terra for $1 worth of Luna . If Luna is trading at $0.10, then one Terra can be exchanged for 10 Luna. If Luna is trading at $20, then one Terra can be exchanged for 0.05 Luna. It doesn't matter. The price of Luna is arbitrary, but one Terra always gets you $1 worth of Luna ; and vice versa, one can always exchange $1 worth of Luna for one Terra .
9. You set up an automated smart contract -- the " algorithm " in "algorithmic stablecoin" -- that enables people to exchange their Terra for Luna, or Luna for Terra.
10. Terra should trade at $1 . If Terra is trading for more than $1, people — arbitrageurs — can buy $1 worth of Luna for $1 and use it in exchange for a Terra that costs more than $1, capturing the middle price difference for instant profit. These arbitrage trades push the price of Terra back to $1 regardless of whether the price of Terra is above or below $1.
11. The price of Luna fluctuates . As time goes on and trust in the ecosystem grows, the price of Luna will likely increase. But this is not important to the concept of stablecoins. As long as Luna has a non-zero value, you can exchange one Terra for $1 worth of Luna , which means Terra should be worth $1, which in turn means its value should be stable.

All of the above, I think, are pretty straightforward and correct, except point 7 which is pretty crazy . If you get past that, i.e. if you can find a way to make Luna have a non-zero value, then all is well . It's about the whole game. This seems difficult in theory, since Luna is something you made up. But in practice, it seems easy, because someone has already created a lot of these cryptocurrencies, and they are now worth billions of dollars. The main methods it uses are:

• Collect some transaction fees from those who exchange Luna for Terra or Terra for Luna, and then pay some of these fees to Luna holders , which is actually the income generated by their staking Luna; or by allowing UST holders Depositing UST into the Anchor money market for interest yield creates demand for Luna , which can be exchanged to Terra for this interest yield.
• Build an ecosystem of smart contracts, programmable money, etc. on top of Terra and Luna so that people will see Luna as a way to use the ecosystem - like stock in the company you're building — thus giving Luna a lot of value .

These things reinforce each other: the more fees you collect and distribute to Luna holders, the bigger and more vibrant your ecosystem is, the more people value it, the more Luna they buy, and you The greater the amount of ecological activity in , the more fees you collect, and so on.

But there's no magic in it. There is no algorithm that can guarantee that Luna will always be valuable . The algorithm just allows people to exchange Terra for Luna. If people think Luna is valuable and believe in the long-term value of the system you're building, then it's valuable; but if people don't, it's not valuable.

The danger here is that point 7 never goes away . Any morning, people might wake up and think, "wait a minute, you made this up and it's worthless" and decide to dump their Luna and Terra.

If people decide to dump their Luna, the price of Luna will drop.

If people decide to dump their Terra, the price of Terra drops from $1 to say $0.97 , and arbitrageurs step in and buy Terra at $0.97 and exchange it for $1 worth of Luna. (Remember: A Terra can always be exchanged for $1 worth of Luna as long as the Luna has a non-zero value.)

The problem is, if people lose faith in the system, they decide to dump Luna and Terra. Someone sells some Terra for $0.97, and an arbitrageur steps in, buys Terra for $0.99, and exchanges it for $1 worth of Luna. Assuming the current price of Luna is $40, then each Terra will allow you to exchange 0.025 Luna. The arbitrageur will then sell the 0.025 Luna in the market, which will drive down the price of Luna (because of the selling pressure), even though its price is also falling. Then another person also sells some Terra, but at this time the price of Luna drops to $20, so that each Terra can be exchanged for 0.05 Luna, the arbitrageur steps in and sells the 0.05 Luna, and then the Luna price drops to $10 , so that each Terra can be exchanged for 0.1 Luna, and then arbitrageurs continue to intervene and sell the 0.1 Luna, and then the price of Luna becomes $5, so that each Terra can be exchanged for 0.2 Luna, and so on. There is no natural end to this process , because Luna is just something you made up, and since it essentially represents people's confidence in the ecosystem, that confidence will fade as the price of Luna collapses. So in the end, the transaction price of Luna dropped to $0.0001, so that each Terra can be exchanged for 10,000 Luna, and then you try to sell Luna, but no buyer is willing to buy, so no one will want to arbitrage the price of Terra, So the price of Terra drops below $1, and then everyone abandons this stablecoin and its ecosystem, and everything goes to zero.

The technical term is called a " death spiral ". Interestingly, this term is also used for " death spiral financing " or " death spiral transformation " in traditional finance, both of which work on exactly the same principles. A "death spiral conversion" is a company's bonds that can be converted into that company's stock at a floating rate so that every $100 of bonds can be converted into $100 worth of stock regardless of the market price of the stock . If the stock price is $40, each bond can be converted into 2.5 shares, worth $100. If the company is profitable and the stock price is stable, then it's fine. But if the company runs out of money and can't pay back the bonds, the stock goes down, and then each bond converts into a lot of shares, selling that stock pushes the stock down even more, converting another bond creates more shares, which get sold Sell, and the stock price drops further, until eventually the stock price drops to $0.0001, and each bond can be converted into 1 million shares, and these shares have no buyers and become worthless.

This is well known in traditional finance, but to be fair, companies still sometimes do death spirals. However, in the Crypto space, people are more willing to believe in perpetual motion machines, and there are many complex narratives about the ecosystem and staking rewards in the field, which you can throw at users to distract people from the basic mechanics, so.. .Look, even though this is also a well-known thing in the crypto space and a lot of people are skeptical about algorithmic stablecoins, people keep doing algorithmic stablecoins.

Terraform Labs’ USD stablecoin , TerraUSD (UST), has experienced a death spiral this week . (I will use "Terra" and "UST" interchangeably to refer to this stablecoin.) UST dropped as low as $0.30 several times last night ; The dollar anchor is far apart .

Meanwhile, their other currency, Luna — a currency you can use to convert to Terra — is trading at about $2.20, down about 93% in 24 hours and down about 97% from last week. % . If you exchanged 1000 Terra for Luna last week, you could get 11 Luna; if you did this morning, you could get 450 Luna. Bloomberg reporters Muyao Shen and Philip Lagerkranser report:

Controversial algorithmic stablecoin TerraUSD plummeted on Wednesday, with the crypto market awaiting a rescue led by its main backer, Do Kwon.
UST fell further to around 50 cents by 10 a.m. in London on Wednesday, wiping out billions of dollars in value, data compiled by Bloomberg showed.

We are in the process and I don't know how it will end. The team behind Terra includes Terraform Labs, the entity that created it, and Do Kwon, the Korean entrepreneur who founded Terraform, the "King of Madmen." There's also the LunaFoundation Guard (LFG), an entity run by Do Kwon and others that seeks to defend the UST's peg to the dollar. They are working on a solution.

Do Kwon, Co-Founder and CEO, Terraform Labs

There are three possible basic solutions. The first solution is : Embrace a death spiral ! It's not exactly a solution, but it is... if you put your money in an algorithmic stablecoin, it's because you trust the algorithm to work, and when you follow that algorithm all the way to its natural end , a death spiral occurs. This morning, Do Kwon tweeted out his remediation plan. One element of the plan is to issue more Luna so that 1 Terra can be reliably redeemed for $1 worth of Luna, even if it means issuing billions of Luna. Do Kwon wrote:

First, we support community proposal 1164 to increase the base pool from 50 million SDRs (Special Drawing Rights) to 100 million SDRs*). Decreasing PoolRecoveryBlock from 36 to 18 will increase minting capacity from $293 million to $1.2 billion. ...
Given the current on-chain spreads, peg pressure, and UST burn rate, UST oversupply (i.e. bad debt) should continue to decline until parity is reached and spreads begin to heal.
Of course, this is costly for holders of UST and LUNA , but we will continue to explore options to introduce more exogenous capital into the ecosystem and reduce the oversupply of UST.

Basically, people are now having trouble exchanging their Terra for Luna; the smart contracts that facilitate this exchange cannot mint new Luna fast enough, so the price of Terra has dropped below $1, arbitrage The mechanism doesn't work. This proposal will speed up the minting of Luna to clear the backlog of exchange orders:

By allowing more efficient UST burning and LUNA minting, it will put (downward) pressure on LUNA price in the short term, but will be an effective way to get UST back to peg, which will eventually stabilize LUNA price.
Indeed, billions of UST will be burned and LUNA will be significantly diluted . However, there is no limit to the supply of LUNA, and this market mechanism will actually lead to stable UST and stable LUNA price (although the price of LUNA may be lower).
If there is no effective burning/minting for a period of time, this may cause UST to lose its anchor for a long time, which will greatly weaken the confidence of the market and continue to encourage speculators to depress its anchor, which may destroy the entire Terra ecology system.

This is literally saying "do a death spiral"! You issue an infinite amount of Luna so that anyone who wants to sell UST can immediately get $1 worth of Luna. “There is no limit to the supply of LUNA,” the proposal said, as if that was a good thing.

The second solution is for the LFG Foundation to enter the market and buy a large amount of Terra to stabilize its price . To do this, you need money (i.e. bitcoin, ether, etc.). As we discussed, Do Kwon was actually prepared for that possibility; that's what LFG does. When things were good—that is, when Terra was popular and Luna was valuable—LFG minted a lot of valuable Luna and used them to buy a lot of Bitcoin. So this week LFG has a lot of bitcoins and can use them to buy Terra on the market. (Or, more intuitively, swap Bitcoin for dollars and use the dollars to buy Terra.)

This supports Terra's price, but it has some drawbacks. One downside is that LFG is selling a lot of bitcoin, driving down the price of bitcoin. Another downside is that LFG has limited ammo: if it spends all its bitcoins and Terra's price continues to drop, it won't be able to continue supporting it. Another downside is that LFG is taking a big risk: if it buys a lot of Terra at $0.50 and then runs out of bitcoins, but Terra continues to fall in price, then LFG has wasted all those bitcoins, and Terra becomes worthless; on the other hand, if it buys a batch of Terra at $0.50 and the price of Terra rises back to $1, then LFG makes a 100% profit on the transaction.

I don't know if LFG is out of money, but the point is, it's a risky deal, but it could also be a good deal . If you buy UST for $0.50, you either make 100% or lose 100% . You may find out quickly; it's not the kind of thing that drags on for months. LFG has been conducting such transactions, and Do Kwon's plan includes "various options for introducing more exogenous capital into the ecosystem and reducing UST's oversupply." That is: you're going to find other people willing to bet that you can stabilize Terra, and then you use their money to buy more Terra at a discount. If it works, Terra will snap back to $1 and they'll be rich. According to The Block:

According to three sources familiar with the matter, the Luna Foundation Guard (LFG) is a Singapore-based non-profit organization that aims to support the Terra blockchain ecosystem. The group is seeking to raise more than $1 billion to prop up the UST algorithmic stablecoin after it lost its parity with the U.S. dollar. ...
The group is now looking to raise fresh capital from some of the industry's largest investment firms and market makers, the sources said. The deal, which is currently being negotiated, will offer investors the opportunity to purchase LUNA tokens at a 50% discount , although the tokens will be subject to a two-year redemption schedule.

50% off? Luna was trading above $70 over the weekend and below $2 this morning. The two-year redemption period seems too long.

A third and related solutionis essentially to restore the market's general confidence in Luna and Terra . I don't know exactly how to do that, but my basic point is that this whole thing is balanced with investor enthusiasm for Luna, and getting that enthusiasm back is critical if you want to get things going again. The renewed investor confidence comes in part from Do Kwon being cool and confident on Twitter . On Monday, he tweeted: "More capital to be deployed": Great! On Tuesday, he tweeted: "UST recovery plan to be announced soon. Hang in there": Well, good! Today he tweeted: "Dear Terra community..." Good job!

Another part of regaining investor confidence is the introduction of external capital . As I mentioned above, this not only gives him more ammunition to buy UST, but also represents some kind of external recognition, a vote of confidence in Terra. Ideally, you could raise $1 billion from Warren Buffett to buy Terra; it would be surprising, but very effective! It would be interesting to get the Federal Reserve (Fed) involved. What about Elon Musk? Vitalik Buterin? Raising $1 billion from a large crypto market maker with a vested interest in Terra isn't exciting, but it's still a big deal.

The other part is focusing on the ecosystem, the utilities, and the benefits of owning Terra and Luna so that big investors are more interested in putting money in and smaller investors feel more confident about owning Terra and Luna. After all, Terra started from nothing and grew to be worth $18 billion. It's not for nothing, either; as of noon, it had a market capitalization of just over $9 billion. "We have a $9 billion ecosystem, programmable money, smart contracts, staking rewards" is still a good narrative, better than when the ecosystem was worth $0, even though things have gone in the wrong direction lately . Yesterday, Do Kwon tweeted:

The Terra ecosystem is one of the most active in the crypto industry, with hundreds of passionate teams building category-defining applications. As long as these builders and Terraform Labs keep building, we'll get through this together.
Terra's focus has always been around a long-term time frame, and another setback in May, similar to last year, won't stop #LUNAtics. Short-term setbacks don't determine what you can accomplish.
What matters is how you respond.
Terra's return will be a sight to watch.
We are here to stay. We will continue to make noise.

I want to emphasize that this is not how dollar bank accounts work at all. If your bank sends you a letter saying, "Oops, we misplaced half your money and now your dollar is only worth 50 cents, but we have hundreds of passionate teams building the definition category app, we're here to stay, we're going to keep making noise, "It's not only bad, it doesn't make sense. You would reasonably respond: "I don't care about your passionate team, apps, and noise. Your shareholders might be interested in this stuff, but I'm a saver and I just want my money back. I just want A dollar in the bank is worth a dollar."

But in an algorithmic stablecoin, these things are mixed together: whether your Terra is worth $1 or not is because people believe or not believe in Do Kwon, Terraform Labs, these teams, applications, ecosystems, and Luna . The bottom line is to make an equity bet on the growth of the system .

In a way, the whole point of the system is to make Terra reliably worth $1, and this week you can see how that confidence has been shattered! These passionate teams basically created a stablecoin worth $1 and it's down to 30 cents! Not so good! But there are other things to talk about. "What matters is how you respond."

Another thing, I've been talking here that the price of Terra and Luna essentially reflects user confidence in those things. If people have faith, Luna has value and Terra is worth $1; if they lose faith, Luna will fall and Terra will collapse.

But in the real world, it's also possible that someone is shorting Terra and Luna: not only can you hold Terra (and hope it's pegged to USD) or not hold it, you can also short it and try to profit from its depeg . People seem to think, more or less, that Terra's loss of the USD peg was caused by an attack in which someone deliberately dumped UST in order to make money from Terra's decoupling. A popular and somewhat convoluted version of this argument is that someone was long UST, shorted Bitcoin, then sold their UST and profited from Bitcoin's price drop because LFG sold Bitcoin , to defend the UST anchor.

This makes sense: death spirals can be self-fulfilling, but people need to be motivated to start them . Once someone does that, and Terra loses its peg to the dollar, there is an incentive to flock to the market: if Terra is at $0.50, and you think it's going to be close to zero, then you should try to trade at $0.50 Sell it, then buy it back for zero dollars (of course if you are wrong, you have to buy it back for $1). The cost of borrowing to short Terra and Luna is currently astronomical, as it is a high-risk but potentially rewarding trade. Just as Do Kwon and LFG, and perhaps his capital partners, are rushing to buy Terra to shore it up, other traders are rushing to sell it to destroy it.

In good times, algorithmic stablecoins basically work because everyone wants to get rich. If everyone believes in the ecosystem, if they believe in the staking rewards of the Luna token, if they believe in the stability of the Terra token, if they believe in the interest rate of the Terra token, then it all works and they can all get rich. But once decoupled, the calculations change. Now, you can get rich long Luna if Terra anchors the recovery, but you can also get rich short Luna if it doesn't. Everyone is no longer shorting or longing it together, and it is still unknown which side will win.

**This article only represents the views of the original author and does not constitute any investment opinion or suggestion.