Sounds unstable: Fluctuations in Terra and GYEN stablecoins make billions disappear

Coinbase’s customers have recently filed a lawsuit against the company over the alleged loss of billions of dollars due to their role in promoting and trading the GYEN stablecoin. According to the suit, GYEN was promoted by Coinbase and the stablecoin’s issuer GMO-Z as a 1:1 peg to the Japanese Yen, despite its vulnerability to breaking. When the peg broke soon after trading started, multiple investors bought GYEN assuming a 1:1 peg, when in fact the stablecoin had become several times more expensive.

This lawsuit adds to the current apprehension around cryptocurrencies, which is spurred by stories of “safe bets” turning into disasters, like that of the stablecoin TerraUSD plunging to 12 cents from its 1:1 peg to the US dollar (as of Monday, May 16). Since stablecoins are supposed to be immune to the volatility attributed to other cryptocurrencies, these stories strike at the heart of what investors fear about cryptocurrencies: their unpredictability and instability.

Terra and Luna: Algorithmic Stablecoins On The Precipice

Not all stablecoins are created equal. Collateralized stablecoins maintain their peg through financial reserves like the US dollar, bonds or gold — well-known examples include Circle’s USDC and Tether’s USDT. However, algorithmic stablecoins like Terra’s UST, usually rely on two tokens (in UST’s case, on LUNA) whose supply and demand are managed by an algorithm that tries to ensure that the coins remain stable at their 1:1 peg.

However, on May 7, UST was unpegged from the US Dollar, as Anchor, the largest DeFi network on Terra’s blockchain, started to experience large amounts of withdrawals. While some speculate that these withdrawals could be an attack, others think they are a result of panic in the face of unfavorable market conditions. 

We spoke to Omid Malekan, an adjunct professor on blockchain and cryptocurrency at Columbia Business School, to understand where the instability in stablecoins was coming from. According to him, Luna’s crash may have started due to an attack, and several events point to the possibility: “For example, the timing of when somebody started draining liquidity from some of the curve pools, the fact that it happened on a weekend at a time where there wasn't much else going on in the crypto world.”

However, Malekan emphasizes that in a “truly decentralized blockchain”, this shouldn’t matter. To him, the whole idea behind blockchain infrastructures is their resiliency in the face of constant attack. Malekan’s research showed that despite claims to decentralization, almost half of LUNA was owned by TerraForm labs, and they also own almost a third of Anchor’s governance tokens. He points out that unlike Terra, Ethereum’s Compound is managed by a separate team of developers, which may be an “indicator of decentralization going on”.

Amidst the crash, when parties like the CEO of Binance accused Terra of mismanaging the depegging, it became apparent that the team behind UST and Luna was caught off-guard, and so was their algorithm. On May 11, Terraform Labs creator Do Kwon published a report stating that their algorithm couldn’t “facilitate the minting of LUNA at the speed needed to repeg the UST”.

Despite being a lot more successful than other algorithmic stablecoins, the depegging of LUNA has once again raised questions around the efficacy of stablecoins. According to Malekan, Luna had independent utility because it functioned as a Proof of Stake token for Terra’s blockchain and the company seemed to have something different in mind when the token first launched:

"The original plan was to integrate UST into a payment app called Chai, I believe. Like, if you go and read the original Terra white paper.., they really focused on demand, which was good because the more in demand any currency is, the less likely people are going to panic and sell it if things look like they're going wrong. But at some point, they pivoted to growing demand via the 20% anchor yields. That ended up being a bad idea. "

While Malekan’s comments paint a grim picture of the future of algorithmic stablecoins, he isn’t alone. Others like Justin Rice, the VP of Ecosystem at Stellar Development Foundation, share his skepticism:

“What we're seeing now, and not for the first time, is an optimistic balancing mechanism unraveling due to natural human responses to market conditions. It is challenging to have algorithmic stablecoins keep their peg when things go sideways, and you have to rely on outside intervention to set things right.”

According to Rice, in order to succeed, stablecoin issuers must maintain public confidence as well as ensure that their supply is sufficiently backed by fiat collaterals. Moreover, he suggests that they must publish third-party attestations of their reserves. "Ideally, they should provide a definitive, on-chain link to that attestation. When it comes to all forms of digital assets, it's often a good idea to lean into the transparency a public ledger provides. Inform the public, and encourage them to keep their eyes open," he said.

Ever since May 8, the need to establish transparency and trust has been thrown in sharp relief. According to Malekan, the whole thing wasn’t as decentralized as promised, which not only affected how resilient the blockchain was, but also impacted how moments of crisis were handled. Since it is still unclear whether the crash was set off by an attack, multiple concerns regarding who was to blame, conflicts of interest, as well as how the reserve bitcoin should have been spent, remain largely unanswered.

Whenever wealth is lost on this scale, people not only need parties to blame, but calls for increased regulation also become abundant. Due to the novelty and complexity of blockchain technology, governments are still playing catch-up with products that are changing every day. Malekan thinks that if regulations are applied without considering how decentralized a blockchain is, it can adversely impact the growth of blockchain technologies. According to him, if a blockchain is fully decentralized and community controlled, regulators can leave it alone.

Hard Fork in The Road

On May 18, Do Kwon proposed a hard fork in the Terra blockchain, which would effectively do away with UST and utilize LUNA (currently trading at near-zero) as the cryptocurrency for the new blockchain. According to Kwon, both chains will coexist, with the old one being called “Terra Classic”. However, a forum poll consisting of 7000 votes shows that 92% of the community is against the fork. According to Malekan, this would turn the Terra Blockchain into yet another layer 1 blockchain, of which there are already so many. Kwon insists in his tweets that this fork shows that even without the UST, there is something worth preserving in the Terra ecosystem. However, it is unclear what differentiable value this preserved ecosystem will offer its users.

Finding Stability

Our conversation with industry experts made it clear that UST’s fall has not only dealt a serious blow to algorithmic stablecoins, but has also reaffirmed the need for fiat-backed stablecoins like USDC. However, when confronted with the GYEN case, where multiple customers still blame Coinbase for locking them out of their accounts while the company worked on the stablecoin glitch, it is apparent that even non-algorithmic stablecoins can suffer irregularities when technical issues arise or when the market behaves unpredictably. In the aftermath of these events, both stablecoin issuers as well as exchange platforms will have to work harder to win back investors, something that can only be achieved by re-establishing transparency and trust in the market.