Could Terra Be the Biggest Stablecoin in the Crypto World?

The stablecoin wars are heating up — and there are many moving parts to this conversation. I have been a Terra user and investor since early 2021 and have seen the project evolve. On February 2, 2022, I wrote an article titled "8 Reasons to Support the 'Roaring' Terra Ecosystem" to welcome the Lunar New Year, and prices have continued to trend upwards since then. As of April 11th, the LUNA token is experiencing a pullback, but this is a natural phenomenon after a rapid rise of more than 100% in a short period of time.

To differentiate an important point, this article is less about the price of LUNA and more about how Terra has the fundamentals to become the dominant stablecoin in DeFi, and the potential to significantly disrupt the largest market in crypto: currencies .

We'll discuss why below, but before we get there, let's start with a quote from a Coindesk article from July 6, 2021, which illustrates just how big UST could become if successful.

“An algorithmic stablecoin is a stablecoin that stays pegged using only software and rules. If one works, it can scale infinitely to whatever size the economy requires”.

Yes... unlimited.

The question arises: Does UST have enough powerful software, rules, and backers to make it the largest stablecoin in the world? Let's take a look.

stable currency

The rise of stablecoins started in early 2021, and the growth rate is amazing. The total market capitalization is climbing to $200 billion (as shown in the chart below), and this trajectory is likely to continue for the next decade and beyond.

Image credit: The Block

Matthew Gould, CEO of Unstoppable Domains, predicts that the stablecoin market could reach $1 trillion by 2025 — a roughly five-fold increase in three years. This seems reasonable given the growth paths illustrated by the aforementioned leaders USDT, USDC, BUSD, UST, and DAI. Even at $1 trillion, it's still a tiny drop of water compared to the ocean-scale foreign exchange market worth $2.4 trillion (or $2000+ trillion).

As of this writing in the first week of April 2022, TerraUSD, known as UST, has a market capitalization of $16.5 billion, or roughly 9% of the entire stablecoin market. If the total stablecoin market cap reaches $1 trillion, and extrapolated from UST's current share, this could result in a UST supply of approximately $100 billion. This will cause a large amount of LUNA to be burned, causing the price to increase. Models developed by economist Murray Rudd suggest that LUNA could cost between $750 and $1,000 by early 2024.

Image source: Twitter

Reminder to my fellow investors - this is a long game, consider your goals and time horizon.

A CBDC wrench in development

There are potential headwinds preventing the mass adoption of stablecoins, i.e. Central Bank Digital Currencies (CBDCs). Although some thought leaders believe that heavy regulation of centralized tokens may drive users to decentralized stablecoins, such as UST, or other emerging projects, such as USN.

Regulation of fiat-backed stablecoins (i.e. USDT/USDC) may actually benefit decentralized algorithmic stablecoins like UST, since it is harder for central governments to regulate and intervene in decentralized markets. Who will they go after?

While the regulatory debate is contentious, I don't think this will be the be all and end of cryptocurrencies. In some cases, regulation is unavoidable, and there are some good arguments for how it could benefit the field. We are seeing more action from the government, in fact, the UK Chancellor of the Exchequer (equivalent to the US Treasury) recently announced:

"Stablecoins will be brought under regulation, paving the way for their use as an accepted payment method in the UK".

This means that the U.K. now joins other jurisdictions such as the U.S., Germany, Portugal, Switzerland, the UAE, and Singapore that are taking steps to further adopt stablecoins.

Will the reign of the stablecoin incumbent (USDT/USDC) come to an end?

USDT/USDC remain the undisputed market leaders with market caps of $82 billion and $52 billion, respectively. However, there are some concerns with both projects:

• USDT has failed to win over the crypto market, with people not believing it has sufficient and legitimate reserves to back its circulating supply.
• USDC is considered more trustworthy than USDT due to its affiliation with Coinbaise and proof of regular reserve audits. However, since currencies are managed centrally (as opposed to decentralized), this can make them vulnerable to the whim of governments looking to impose a regulatory crackdown.

Another option is DAI, which has an inefficient capital model where you have to be overcollateralized to mint the stablecoin. For example, you must stake $150 in USDC to mint $100 in DAI.

Many believe that the decentralized and algorithmic stablecoin UST may be the best solution to strike the perfect balance between the following tradeoffs:

• Centralization vs. decentralization (e.g. censorship resistance)
• Transparent vs. opaque (e.g. proof of reserve audit)
• Capital model (e.g. degree of collateralization)

To see why UST developed its own, dare I say it is indisputable.

The Trillion Dollar Question: Can UST Stay Pegged?

Most of the criticism has focused on the possibility of a bank run and the resulting UST decoupling event, so let's start there. This is a legitimate concern, as all previous algorithmic stablecoins (such as Iron Finance) have failed, and TradFi bank runs have occurred throughout history.

It is important to understand that there is an algorithmic relationship between UST and LUNA, so 1 UST equals 1 USD of LUNA. This is in stark contrast to debt-backed stablecoins such as DAI, which are over-collateralized (i.e. not at a 1:1 ratio) by external assets such as Ethereum and USDC.

To illustrate the idea with a simple analogy, you can think of LUNAs as being similar to gold bars that have high monetary value but are unsuitable for use as a medium of exchange (mainly due to price fluctuations). You can use LUNA to mint UST, which is like a gold coin and is easier to use as a medium of exchange with little price risk. Again, you can always reverse the process by smelting coins into liquid gold and recreating solid gold bars (i.e. exchanging UST for LUNA). UST and LUNA are essentially the same material, but expressed in different forms.

Algorithmic stablecoins require no debt or external collateral. As a result, they are more capital efficient (i.e. require less upfront capital to drive returns) and can grow faster than their debt-based peers. However, this also means they are more vulnerable to the tail risk of a black swan event such as the Covid-19 pandemic, which could theoretically trigger a "death spiral".

Jose Macedo, founding partner at Delphi Ventures and head of Delphi Labs, provided the following two scenarios that could lead to the same outcome; LUNA supply expansion leads to price drop.

Essentially, since $1 of LUNA is a $1 of reserve asset (i.e. endogenous collateral), we could see a self-reinforcing positive cycle that is doomed to destruction. In theory, this is how reflexivity works:

• UST contraction causes LUNA to be cast
• LUNA Price Drops on Supply Expansion
• Rising Fears Drive More Dollar Redemptions - Death Spiral Continues...

To date, no algorithmic stablecoin has succeeded. It's also important to realize that all algorithmic stablecoins to date have had poor utility . On the other hand, there are reasons to be cautiously optimistic about Terra being the first successful algorithmic stablecoin:

1. UST has enormous utility.

2. Terra has proven its resilience so far, such as the crypto market-wide pullback in May 2021.

3. Terra recently embarked on its Bitcoin (and AVAX) acquisition spree to build a stronger defense against UST's USD peg.

4. Wealthy backers with deep pockets have a vested interest in Terra's success.

Let's briefly explore these 4 points.

1. UST has enormous utility

To quote Do Kwon:

"Money (UST) is just a technology with three use cases, you can hold it, invest it or use it".

Terra enables you to hold UST on Anchor, deploy UST on Mirror as collateral to facilitate investment and spend TerraKRW (Korean Won) using Chai. Literally, the ways to use UST are increasing every week. See the Terra ecosystem map below.

https://dashboard.incryptohub.com/blockchain/terra/

The success of the Terra ecosystem can be measured by looking at the rate and level of UST adoption both internally and externally:

• Internally - native UST held on the Terra blockchain.
• Externally - UST has been bridged to other blockchains such as Ethereum, Solana and Avalanche.

Messari confirmed that UST has the fastest growing supply and usage of any stablecoin.

Network effects are everything in the stablecoin market. Since UST is the fastest and purest dark horse, it's hard to bet on.

2. UST Peg is battle-tested

In May 2021, the market crash caused the price of LUNA to drop by more than 70%. This threat-pegged pullback was exacerbated by the liquidation cascade of Anchor (a savings protocol that requires borrowed amounts to have a specific loan-to-value ratio) and failed oracle transactions caused by network congestion. With the support of the buyer of last resort, Terra survived and restored the UST peg. Over the past 12 months, Terra has grown significantly in terms of funding backers, developers, community size, and application landscape. But what caught my attention the most was their strategy of introducing exogenous collateral, which should create a demand floor in the event of a tighter USD UST going forward.

As cryptocurrency investors, we must accept the reality that we are exploring an unknown technological frontier. UST was the first successful algorithmic stablecoin experiment, and the fundamentals suggest that this success will continue.

3. AD Diplomatic Alliance between Bitcoin and Terra

The Luna Foundation Guard (LFG), a new nonprofit led by Terra ecosystem representatives, has announced a strategy to acquire $10 billion in Bitcoin. Bitcoin reserves will be collateralized by UST, thereby providing greater security for defending UST's peg to the US dollar.

The Exogenous Reserve Fund will initially consist of Bitcoin held by the Luna Foundation Guard (LFG). In terms of security, LFG has a seven-member committee protected by multi-signatures (settings that require multiple signatures to access a cryptocurrency) held by committee members.

What is the key point of this strategy?

BTC reserves will not back UST as a stablecoin. The Reserve will act as a market participant (i.e. a buyer of UST) able to absorb UST supply contractions. In this way, there will be less pressure on LUNA as a reserve asset, in other words, BTC will act as a backstop. Remember that normally when you redeem UST, you mint LUNA (creating supply expansion). Replacing LUNA with Bitcoin can avoid the death spiral due to market uncertainty (see chart below).

With this new mechanism, Terra is on par with central banks and fractional reserve banking. Kanav Kariya, president of Jump Crypto, said the reserve mechanism is "similar to how many central banks hold foreign exchange reserves to support monetary liabilities and protect against dynamic market conditions" - Source: Ryan Weeks @ The Block.

UST is a liability, LUNA, Bitcoin and AVAX are assets.

4. Financial backers

In addition to the 3 factors discussed above, it is also worth noting that there are strong supporters interested in the Terra ecosystem such as Galaxy Digital (investor), 3 Arrows Capital (investor), Jump Capital (investor) and Ava Labs (Partner). It cannot be overemphasized that these backers bring social and financial leverage and are likely what helped Terra survive the severe contraction in USD UST in May 2021.

To illustrate this point, Jump Capital demonstrated their long-term belief in staking and how committed they are to the DeFi space. Most recently, Jump Crypto provided $120,000 in ETH as a bailout (approximately $360 million) during the unfortunate Wormhole Bridge hack. Influential institutions with a vested interest in Terra may do whatever is necessary to maintain Terra's healthy development.

More broadly, VanEck, a global investment manager who oversees over $60 billion in crypto assets and operates a range of crypto ETPs (exchange-traded products, such as ETFs), has just released a ETP This opens the floodgates for an influx of more institutional capital.

epilogue

Let’s get back to the central question of this article: “Can Terra be the largest stablecoin in the crypto world?

Currently, UST represents 1/3 of USDC and 1/5 of USDT. Due to the lack of trust in USDT and the centralization issues surrounding USDC, capital is likely to choose the most mature decentralized and trustless option - UST.

There are many reasons to speculate in favor of UST becoming a major stablecoin:

• Utility - The growing cross-chain demand for UST proves that it can be used in a variety of ways.
• Proven - In May 2021, UST has weathered a severe supply contraction. After 12 months, it's much stronger to withstand these types of scenarios.
• Bitcoin Strategy - Bitcoin is undoubtedly the hardest and most neutral asset in the crypto space. It would be wise to take advantage of Bitcoin to create a stronger UST/LUNA mechanism. The Bitcoin community (in general) also seems to welcome the decision.
• Financial backers - Terra has strengthened its reserves (Bitcoin and AVAX) by forming alliances with companies such as Jump Crypto and AVA Labs. There is an influential power group slowly emerging around Terra, and that should be acknowledged.

If Terra is successful, UST will become the reference stable currency for the entire DeFi, and LUNA will reach more than 5 figures.

Now it is your turn.