Luna Wasn’t on Terra Firma

Algorithmic stablecoins may be a new creation, but they are not immune to some very old problems.

TerraUSD is, or was, the largest. The stablecoin section refers to how it aims to always be worth one US dollar, making it a useful digital alternative to the greenback. The algorithm section describes how it aims to do this: By being swappable for another token, Luna, there is no fixed value. If the value of TerraUSD falls below $1, it can be “burned” and exchanged for a dollar worth of Luna — and vice versa. But that mechanism is clearly broken and TerraUSD is no longer worth $1. It currently costs about 40 cents.

How it failed to deliver is not entirely clear, but there is a component that, as events unfold, there is a rush to get out of both TerraUSD and Luna. And that way, for all its novelty, TerraUSD has managed to run into the same old problem that so-called fiat currencies issued by governments have long tried to avoid: Loss of trust believe.

The word algorithm is a bit distracting. Every digital token has rules and systems as part of its design. Its fundamental difference from other stablecoins is in the way it creates value. Stablecoins like USD Coin or Tether are expected to be backed entirely by cash reserves or familiar instruments like Treasury. In other words, they act more like a classic currency board than a regular peg, with the issued coins being 100% backed by the anchor coin’s reserves.

Meanwhile, an “algorithmic stablecoin” is in some ways like a fiat currency in that it is meant to be pegged to another. Of course it is not government issued and has no central bank. But the word “fiat” also gives the wrong impression of how government currencies develop in value. The Latin word for “let it be done” is most famously combined with the biblical saying, “Fiat lux” – let there be light. Of course, governments are not gods: If a currency is deemed worthless by people, even if it is legal tender, they may look for other ways to store or exchange it. value. Government currencies with pegs considered weak were broken during the Asian financial crisis of the 1990s.

Governments have laws and armies and taxes to support their cause. Terra needs other vehicles. One is to try to fix it to the US dollar through the Luna mechanism to avoid the volatility that typical cryptocurrencies experience. Another activity is to support the funding of income payments to TerraUSD holders through the Anchor Protocol. At a rate close to 20%, that has attracted the inflow of money, with people exchanging US dollars, Bitcoin or Ether to buy it. It also uses a foreign currency reserve – Bitcoin – to partially back TerraUSD.

Cryptocurrency also thrives on social proof: Seeing other people use and value it can reduce its credibility. TerraUSD is probably already starting to achieve this, through payment and investment apps, but it’s clearly not enough. Meanwhile, currencies have to deal with crises. And just as central banks can make policy mistakes, so can software mechanisms on the blockchain. These are being discussed during the autopsy of Terra’s demise.

Whether a committee of central bankers, rather than a consensus of holders, can make better decisions is debatable. Terra and its mechanisms could end up being a more accountable, transparent or fair version of what money regulators do. Despite that, it still requires some of the same trust as a fiat currency.

Calling Terra is some kind of scam that undercuts its ambitions. It’s trying to do no less than reinvent the wheel.

The markets have been looking increasingly shaky lately: Stocks, bonds, and cryptocurrencies are all falling as investors struggle to manage volatile global financial markets. WSJ’s Caitlin McCabe looks at some of the reasons behind the recent market frenzy. Photo: Spencer Platt / Getty Images

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