What Terra, Bancor, and the Death Spiral Teach Us About Tokenomics
The vast majority of readers are undoubtedly aware of what happened to Terra in May. Whether you believe it was a direct attack or a perfect storm of external conditions, UST was depegged, and the existing supply contraction mechanisms were ineffective in resolving the situation. This caused a large-scale and permanent depeg, bringing both Luna and UST to near-zero levels.
This massive $35 billion dollar collapse exacerbated the deterioration of the crypto and global asset markets. Though many had previously denied it, the majority of market participants began to universally agree that markets were in true bear territory only after Terra’s collapse, despite the fact that it was realistically made official closer to January.
Organizations and projects with too much crypto exposure will become insolvent, as is customary in bear markets. Celsius, a popular centralized crypto lending service, is essentially bankrupt because it lacks the liquidity to repay depositors, owing in part to overleveraging into the staked ether. Three Arrows Capital, abbreviated as 3AC, also declared bankruptcy recently. There’s no doubt that 3AC’s demise was caused in part by their massive involvement in Terra, which cost them nearly $200 million.
Many defi projects that rely on external cash flowing in to stay alive, like insolvent organizations, will reach zero and eventually fade away. Celsius, a popular centralized crypto lending service, is essentially bankrupt because it lacks the liquidity to repay depositors, owing in part to overleveraging into staked ether. Three Arrows Capital, abbreviated as 3AC, also declared bankruptcy recently. There’s no doubt that 3AC’s demise was caused in part by their massive involvement in Terra, which cost them nearly $200 million.
Bancor is a decentralized exchange, or DEX, where users can trade tokens. Defi Llama ranks it as the 5th largest DEX on Ethereum and the 20th largest DEX overall, despite losing 70% of its TVL in the last month. Bancor is distinguished from other DEXs by its “permanent loss protection.”
Impermanent loss (IL) refers to an LP’s diminished gains or amplified losses relative to dollar value when the price ratio changes from when they put the tokens in. Simply put, if the prices of the assets in a pool change relative to each other, losses caused by an asset depreciating are amplified, and gains caused by an asset appreciating are amplified.
Bancor aims to protect its users from temporary loss by minting its native token, BNT. Any IL for which Bancor is unable to compensate with accumulated swap fees is compensated with newly minted BNT. Bancor distinguishes itself by allowing single-sided staking. While this is normally impossible when LPing, Bancor makes it possible by pairing deposits with minted BNT under the hood and then burning this BNT (minus any IL protection) when the user withdraws.
This IL protection payout is added to the circulating supply and is frequently immediately sold off by the recipient for the original deposited asset.
Primer on Terra
Terra UST was an algorithmic stablecoin that was pegged to the US dollar and was created by burning $1 of Luna at the current market rate. For example, if Luna was trading at $0.50, it would take 2 Luna to generate 1 UST. When Luna was worth $100, that same UST would only cost 0.01 Luna to produce. The burning mechanism could also be reversed. 1 UST could be burned for $1 in newly minted Luna. This mechanism is what kept the UST pegged. When UST was under pegged, it could be purchased for $0.99, burned for $1 of Luna, and then sold for a 1 cent profit.
Many external factors contributed to Terra’s demise, but those are beyond the scope of this discussion. See Coincu’s excellent piece for an in-depth look at the exact timeline of all the action surrounding the UST collapse. The infamous “death spiral” was responsible for Terra’s demise. The death spiral is a term used to describe a phenomenon that appears to affect all algorithmic stablecoins.
Terra’s Collapse in Summary
1. UST is trading below the $1.00 mark.
2. Scared UST holders start selling UST UST does not regain its peg as a result of the selling
3. UST is being burned in order to mint more. Luna
4. The cost of Luna has decreased.
5. Scared Holders of Luna begin to sell Luna
6. Luna’s price continues to fall.
Because they are unwilling to accept the financial loss caused by the minting of more Luna, Luna holders will sell their volatile assets. This means that Luna, the supposed backing asset of UST, is depreciating not only due to inflation, but also because its own holders are selling it off. This dual effect implies that there is insufficient value in Luna to restore the peg of UST to $1, causing more UST to be dumped, causing exponentially more Luna to be minted, and bringing the entire system to a halt. Luna’s supply increased from 700 million to 6.5 trillion. After reaching this supply, and long after the price of Luna was effectively zero, the Luna burning mechanism was activated.
Bancor paused its impermanent loss protection on June 19th, 2022, similar to how Luna and UST burning and minting were paused. This was due to the adverse market conditions brought about by the massive and rapid selloff of crypto assets. BTC had its worst month ever in June 2022, losing 38% of its value in 30 days. This, of course, caused other crypto assets like ETH and BNT to suffer the same fate, if not worse, stress testing many defi systems, including Bancor’s IL protection.
The fact that IL protection was paid out in newly minted tokens is analogous to redeeming UST for Luna. The similarities are particularly striking in that holders of the “asset” token (BNT or Luna) are expected to incur losses when it comes time to repay the debt (Impermanent loss or UST redemption). This system works well as long as both systems grow and debt claims remain low. After all, Luna’s UST functioned perfectly during periods of expansion and minor contraction, and could only fail when a massive contraction occurred in a short period of time.
Bancor’s collapse in summary
1. The depositor withdraws from the Bancor pool and receives minted BNT to cover the temporary loss.
2. They sell BNT, causing the price to fall and increasing the temporary loss for all other depositors.
3. Other depositors withdraw from the Bancor pool, resulting in even more BNT being received to cover even more temporary loss.
4. They sell BNT, lowering the price even further and causing even more IL for the remaining depositors.
Lessons in Game Theory and Tokenomics
This is a lesson in both game theory and tokenomics. When given a high probability that the price will fall, rational actors and investors will sell their tokens. A bank run occurs when the number of investors convinced of the decline reaches a critical mass.
This is a game theory and tokenomics lesson. When the probability of the price falling is high, rational actors and investors will sell their tokens. A bank run occurs when a critical mass of investors are convinced of the decline.
This is the fundamental tokenomics lesson from both Bancor and Terra. In addition to the flaws of elastic supplies, a protocol must own the assets used to repay debts. A protocol’s users or token holders cannot be trusted to bear the burden of financial loss. Few people will keep rapidly depreciating assets “for the cause” or to protect the protocol. People are rational actors, particularly when it comes to money. They will sell the asset and consider buying it back later if they are aware that it will depreciate in order to pay back the debt that isn’t necessarily theirs. That is if it does not reach zero.