The Risks Behind LUNA-UST Stablecoin, According to a Bearish Academic

The Terra ecosystem's breakout success may be "unsustainable," University of Calgary law professor Ryan Clements said on CoinDesk TV's “First Mover.”

AccessTimeIconApr 21, 2022 at 5:55 p.m. UTC
Updated Apr 21, 2022 at 6:13 p.m. UTC

Fran is a writer and reporter at CoinDesk.

In the past year, the space-themed Terra blockchain network has rocketed to prominence. UST, the dollar-denominated digital asset at the center of this financial universe, is now the third-largest stablecoin. LUNA, that stablecoin’s ballast, hovers under $100 and is within the top 10 most-used cryptocurrencies. And the blockchain itself, primarily built and maintained by Terraform Labs, has become a hotbed for decentralized finance (DeFi) and other emerging market activities.

But that growth is likely “unsustainable,” University of Calgary law professor Ryan Clements said on CoinDesk TV’s “First Mover.” Worse, Terra’s principal backers – Terraform Labs, its CEO Do Kwon and the closely related Luna Foundation Guard (LFG) – are seemingly aware of “systemic risks” to its algorithmic stablecoin as they make moves to bolster its reserves and incentivize market demand.

"The fact that Terra is acknowledging the need for reserves suggests that they don't think the ecosystem in and of itself is sufficient to be able to keep this peg,” Clements said Wednesday morning. Clements has long been bearish on “LUNA/UST,” having published an academic review of the mechanics of algorithmic stablecoins and their surrounding financial ecosystem last October.

Backing up: Stablecoins are cryptocurrencies whose value is tied to an outside asset, such as the U.S. dollar or gold, to stabilize the price and are useful in the wider crypto economy. Unlike so-called centralized stablecoins that maintain their peg to the greenback by holding reserves, UST relies on a relationship to its sister token, LUNA. Terra, which is algorithmically burned or minted as UST, U.S.-Terra LUNA floats above or below the $1 mark.

Theoretically, this means LUNA/UST can maintain itself without any assets or collateral. Though, historically, most other algorithmic, or uncollateralized, stablecoins (like Iron Finance's Titan Token) have crashed and burned.

The dynamics of the UST Terra-LUNA relationship have evolved over time. Last month, the recently incorporated LFG and other Terra backers announced plans to add bitcoin and AVAX as reserve assets, which could be sold off in case the relationship between UST-LUNA breaks down.

“Terra-UST was a purely algorithmic stablecoin,” Clements said, adding that with reserves it’s a different “version” of what was originally promised. This isn’t necessarily a bad thing, he said, and even thinks the LFG has validated his predictions made last fall.

“Purely algorithm stablecoins are bound to fail without reserves,” Clements said, and has said. He’s not alone. Ex-International Monetary Fund risk analyst turned financial asset blogger John Kiff told CoinDesk in an email, “Despite Terra's great success so far, I'm not convinced of the robustness of algorithmic stablecoins. This all sounds very 2007-08ish!"

But the UST-Terra LUNA relationship still has its risks, as many bears are wont to note. There’s the natural volatility of the crypto market, the “inherently fragile” relationship in the LUNA-UST arbitrage and the risk that Terra’s use cases built around UST aren’t actually used. Perhaps the largest risk comes from the Terra-based Anchor protocol, a “decentralized” lending platform that pays nearly 20% yields to those willing to lend their assets to it. Currently, two-thirds of UST demand comes from Anchor, Clemens said, a phenomenon encouraged by Terraform Labs, which built Anchor to incentivize use of its blockchain.

However, lending demand on Anchor is significantly higher than borrowing demand on the protocol, and as a result, the Terra Foundation has to “inject” capital to maintain the attractive yields, Clements said. (Anchor recently announced it would move to adjusting its yields based on demand, rather than keeping it at an artificial limit of 20%.)

Clements points out that a number of factors could potentially cause instability in Anchor, causing UST to become unpegged, including a competing borrowing protocol taking liquidity out of Anchor. Terra’s staking rewards could also fall, he said, impacting that attractive lending rate.

“Having to inject liquidity into Anchor in order to maintain those yields…that looks very vulnerable to me over time,” he said.

Further, funny as it sounds, Terra’s bitcoin and AVAX reserves add their own risks depending on if they rise or fall. Likewise, Terra’s “unique whale-holder status” could create risks for the wider crypto ecosystem, due to problems of “cascading volatility” if they ever have to sell their bitcoin to maintain UST’s peg.

“My argument is not that [Terra] cannot be stable, my argument is that in order for it to be stable there are a number of assumptions that have to hold,” Clements said.

He is calling for more transparency: Transparency around whether Terra plans to further its reserve strategy, clarity around the conditions in which it might sell its assets as well as other “disclosures and operational controls.”

“[Terra is] looking less and less decentralized over time and much more centralized,” he said.

“If we’re wanting to use this as a form of money, it could be helpful to have some understanding of where the vulnerabilities are and where the control mechanisms are,” he said.


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Fran is a writer and reporter at CoinDesk.

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Fran is a writer and reporter at CoinDesk.