Terra Collapse teaches about ‘Crypto’ and Bitcoin

Terra collapses.

The blockchain project that houses the popular algorithmic stablecoin TerraUSD (UST), which had recently become the fourth largest stablecoin by market value but now sits at the fifth largest, is on the verge of collapse as UST repeatedly fails to maintain its $1 peg and LUNA, the native blockchain token, close to zero.

Terraform Labs, the tech startup behind the development of Terra, halted production of new blocks on the network on Thursday “to prevent governance attacks following high $LUNA inflation and a cost of ‘greatly reduced attack’, he said on Twitter.

A governance attack became less costly due to LUNA’s nearly free price – an attacker could inexpensively acquire enough LUNA tokens to socially attack the network by forcing a majority vote. (Since Terra relies on a derivation of proof-of-stake (PoS) for consensus instead of hardware and electricity as in Bitcoin’s proof-of-work (PoW), coin ownership equates to power. In Bitcoin, the amount of BTC you own does not grant you more power on the network.)

The network went live a few hours later when the hotfix was released.

This is another important difference between a network like Terra and Bitcoin: while in the former a minority of entities can vote on things like shutting down the network, Bitcoin’s true decentralization makes it immune to the whims of any specific group.

How does the UST work?

Stablecoins are digital representations of value in the form of tokens that attempt to maintain one-to-one parity with a fiat currency like the US dollar. Tether (USDT) and USD Coin (USDC) top the market cap charts and are the most popular and widely used stablecoins. However, they are issued (minted) and destroyed (burned) by centralized entities that also maintain the necessary dollar equivalent reserves to back up the coin.

Terra’s UST, on the other hand, sought to become a stablecoin whose minting and burning process was executed programmatically by a computer program – an algorithmic process.

Under the hood, Terra “promises” that people can trade 1 UST for $1 worth of LUNA (whose value fluctuates freely based on supply and demand) at any time. If the UST breaks its upside peg, arbitrageurs can trade $1 of LUNA for 1 UST, capitalizing on the premium with an instant profit. If it breaks the peg on the downside, traders can trade 1 UST for $1 of LUNA as well for instant profit.

What does Bitcoin have to do with it?

Terra gained notoriety within the bitcoin community after Terraform Labs founder Do Kwon said earlier this year that the project would acquire up to $10 billion worth of bitcoins for UST reserves.

The purchases would be made and coordinated by the Luna Foundation Guard (LFG), a Singapore-based non-profit organization that works to cultivate demand for Terra stablecoins and “enhance the stability of the UST peg and foster the growth of the Terra ecosystem”.

As corporate cash allocations to bitcoin have grown in popularity over the past two years on the heels of MicroStrategy’s continued purchases of BTC, LFG’s move represented the first major allocation of BTC as a reserve asset. by a cryptocurrency project. The news was met with a mixture of enthusiasm and skepticism within the community.

Bitcoin Magazine reported at the time that the algorithmic maneuver employed by the UST stablecoin to maintain its peg was of questionable durability, and the bitcoin purchases did not make the UST a “bitcoin-backed” stablecoin. Even Terraform Labs acknowledged that “questions persist about the durability of stablecoin algorithmic pegs.”

Terraform Labs also explained how there must be sufficient demand for Terra stablecoins in the broader cryptocurrency ecosystem to “absorb the short-term volatility of speculative market cycles” and ensure a better chance of long-term success. term. This is what the project was looking for with BTC – to create demand for UST by instilling more confidence in the sustainability of the peg.

How did Terra implode?

Given the many open questions about the durability of such an algorithm-backed peg, Terra’s design did not hold up under stress.

As the UST started to lose its downside peg, additional pressure was consequently put on LUNA due to the massive amount of USTs increasingly trying to get out and trade

As the UST began to lose its downside peg, traders looked to break out by trading each of their USTs for $1 worth of LUNA. However, given the rapid pace of devaluation, a massive amount of UST tried to get out – more than Terra was able to exchange for LUNA. That extended on-chain swap spread to 40% and put additional pressure on LUNA, sending its price strongly south.

The token then descended a “death spiral.”

The UST has struggled to maintain its peg to the US Dollar since Monday. Image source: TradingView.

LUNA touched values ​​close to zero

In a ripple effect, LUNA plunged, falling near zero on Thursday. Image source: TradingView.

What does this tell us?

In short, it can be said that the lesson learned from this is: alternative cryptocurrency projects (altcoins) are just an experiment, while Bitcoin is the only proven peer-to-peer digital currency.

Bitcoin was born out of the ideals of the cypherpunks, a group of like-minded early cryptographers who came together to explore what privacy might mean in the then-coming digital world, particularly as it relates to money.

The cypherpunk movement was born, in essence, from the work of Dr. David Chaum, a pioneer in cryptography who brought mathematical technology out of the hands of government bureaucrats and into the realm of public knowledge. His explorations kick-started an entire line of work, dedicated to finding how society could move peer-to-peer money – cash – into a digitized economy.

With a clear goal in mind, these mathematicians began working out what a solution might look like through research and experimentation. Decades later, Satoshi Nakamoto would put it all together and add his own twist to arrive at Bitcoin, the first and only decentralized, trustless form of digital currency.

As Bitcoin grew in popularity, alternative forms of what has become a cryptocurrency – a currency that exists in the digital realm through the use of cryptography – began to be created. While these coins were initially born to compete with Bitcoin, a whole new set of projects then began to emerge with different value propositions while putting their own spin on the blockchain, consensus, and cryptography that made Bitcoin work.

Nakamoto designed the Bitcoin protocol to take advantage of PoW, a consensus mechanism that relies on computing power and free competition to create new BTC on the Bitcoin blockchain. The bitcoin mining race, as it is known, involves thousands of miners scattered across the world with one goal: to find the next valid block and receive bitcoins as a reward.

Altcoins, however, have mostly moved away from PoW to favor other new consensus mechanisms. The most popular alternative, PoS, allows participants to lock in their holdings of the given project’s native token to become block creators instead of letting them compete with mining hardware and electricity to mine new coins.

While PoW incurs real costs for miners, costs in PoS are simply numerical and represent the amount of money spent to buy those staked coins. The assumption with PoS is that staking those coins ensures that miners have skin in the game and are therefore encouraged to behave honestly, but there is no evidence that such commitment is sufficient incentive. Additionally, in cases where a large devaluation occurs such as with LUNA, the network risks being hit by a governance attack and may find itself forced to take totalitarian actions such as stopping bulk production of what was supposed to be a permissionless and unstoppable decentralized network.

The PoW-PoS dynamic is also important as it highlights the experimental nature of altcoins.

Instead of copying Bitcoin’s model – a strategy that has proven unsuccessful time and time again – new altcoin projects attempt to “innovate” by copying some parts of Bitcoin’s design and modifying others.

As a result, the projects launched today stray from many of the ideals that underpinned the cypherpunk movement that began decades ago. Such projects claim to be decentralized but mostly have a founding team that almost never relinquishes its position of control and can direct every decision that occurs on the network.

With such a drive to innovate, most “crypto” projects end up creating artificial problems that don’t exist to invent a new solution.

Dr. Chaum and the cypherpunks spotted a clear problem in society: how will we have money in the digital age that cannot be spent twice without a centralized authority monitoring the balances? It took decades of research by many expert scientists and mathematicians from different backgrounds to finally come up with an elegant solution to this problem.

Today, however, cryptocurrency teams take only a few years between idea generation and a minimum viable product, not benefiting from organic growth in favor of huge amounts of capital that disproportionately favor insiders at the expense of the regular user.