TerraUSD (UST) has quickly become the leading dollar algorithmic stablecoin. To counter fears of a loss of ties, the protocol is in the midst of a $10 billion plan to diversify its cash reserves with bitcoin and other digital assets.
Algorithmic stablecoins, unlike their centralized counterparts, do not come with collateral. Hence, they are also called insecure stablecoins. The algorithm or protocol underlying these stablecoins acts as the “central bank”. Terra uses a token-burning mechanism that provides financial incentives to arbitrageurs to maintain the dollar peg. To further hedge residual risk, founder Do Kwon announced $10 billion in Bitcoin purchases. In the past few weeks, the Terra protocol has already invested 1.7 billion in Bitcoin (42,500 BTC) and entered the top 20 of the largest Bitcoin holders.
Rapid growth exacerbates risks
The Terra blockchain, with its UST stablecoin and numerous DeFi applications, has established itself as one of the fastest growing ecosystems in the crypto space. Much of the demand comes from the savings protocol Anchor, which offers a very attractive return for stablecoins at almost 20% per year. Today, more than $15 billion in digital assets are deposited on Anchor, making the savings protocol the third-largest DeFi application by total deposited value (TVL).
However, the rapid growth of the Terra ecosystem also increases the risk of link loss. Since the UST is directly tied to the LUNA token, large price swings can significantly affect the binding. Such a loss of commitment occurred during the general market collapse on May 23, 2021, when the 2 billion UST was backed by only 1.6 billion USD in LUNA. The bond was only able to recover when Terraform Labs and other investors bought LUNA and reset the dollar price by 1:1. A comparable event would be devastating with the current number of assets deposited.
Cash Diversification with Bitcoin
Bitcoin is often referred to by investors as “digital gold”. In combination with numerous advantages over precious metals, the crypto asset has established itself as one of the most effective stores of value. In this context, Terra has also decided to hold part of its reserves in Bitcoin.
P2P e-money easier to spend and more attractive to hold #btc
— Do Kwon 🌕 (@stablekwon) March 14, 2022
These decentralized foreign exchange reserves are intended to support the UST stablecoin on the Terra blockchain and be used to cover short-term UST repayments. The protocol has already invested $1.7 billion in cryptocurrency in numerous purchases. This gives Terra the second largest enterprise pool of Bitcoin after MicroStrategy ($3.9 billion).
A systemic risk for the industry
Terra’s billion-dollar purchases provide cover for the native UST stablecoin. But if Terra’s bonding mechanism were to fail, part of Bitcoin’s reserves would consequently have to be exchanged for US dollars. Thus, according to some voices, a possible liquidation of these reserves could create a significant risk for the entire crypto industry.
With 10 billion bitcoins, the Terra Protocol is said to be the largest bitcoin holder alongside pseudonymous founder Satoshi Nakamoto. Selling pressure of this magnitude would inevitably lead to steep price drops even if the coins did not end up on the open market. Do Kwon himself is aware of this, but seems to interpret it as an advantage for his project.
“Besides Satoshi, we will be the biggest holder of $BTC in the world”
“the failure of US$ equals the failure of crypto itself”
— Legomakers 🌖 (@tlagomi) March 29, 2022