Decentralized finance tried to make its way to the market via TerraUSD. Terra is a stablecoin that resurrected following a crash of stablecoins in 2022. Stablecoins are cryptocurrency coins linked to fiat currencies instead of cryptocurrencies to reduce volatility.
Terra was a decentralized payment mechanism that transferred stablecoins from one party to another. The establishment of stablecoins via a payment mechanism was created to make the payment system more balanced and fluctuate less with other cryptocurrencies.
The decentralized financial system has been well received as consumers outside developed countries need financing and a payment system that will provide them with the finance structure they need.
There are a lot of benefits to peer-to-peer lending, and the concept of a stablecoin offers the necessary platform for deregulated finance. Unfortunately, the algorithmic stablecoin concept, where a program runs to stabilize a token, failed in 2022, and TerraUSD was the victim. Here is what was attempted and what played out over time.
What is Decentralized Finance?
The mechanism and concepts of decentralized finance are similar to centralized finance. The difference is that decentralized finance (DeFi) uses blockchain technology and other emerging technologies on a distributed ledger to generate the financial information needed to handle payments and loans.
A centralized financial system uses an overseeing authority like the Federal Reserve in the United States or the European Central bank in Europe to define the rules and regulations used by member firms who engage in finance.
For example, banks are regulated by the Federal Reserve and must abide by those rules to conduct banking transactions in the United States. Any types of reserve requirements that banks need to hold are directed by the regulators that oversee the organization.
In a decentralized system, the concepts are challenged as the financial system is set up by encouraging peer-to-peer lending via a digital exchange instead of direct borrowing from a bank or alternative financial institution regulated by a centralized authority.
Centralized finance is built around the banking system, which charges fees to its customers to make money. Money transfers are usually through a third-party provider that also charges fees. The third party will clear the funds through two centralized financial institutions and receive payment for these services. Each participant in the chain gets compensation for its services which ultimately comes from the customer.
Decentralized finance eliminates fees associated with banks and brokerages that provide finance through a centralized system. Money is held in a digital wallet in the form of a stablecoin. Through peer-to-peer lending, most fees are eliminated, allowing customers to conduct financial transactions without a centralized network and restricting payments.
Decentralized financial transactions use a blockchain as a ledger. All of the transactions are stored on blocks and verified by other users on the platform. The peer-to-peer blockchain transactions are focused on cryptocurrencies as opposed to fiat currencies. There is no third party involved in these transactions.
These scenarios allow users to negotiate loan interest rates with their providers directly. Using smart contracts on platforms generates a record of the transactions that are available for anyone to review but does not reveal the identity of the parties in the trades.
What is Terra?
To transact decentralized finance, you will need a blockchain platform. Terra is a blockchain mechanism for an algorithmic stablecoin that allows cryptocurrencies to track other assets. Terra is open-source software. The term open source software refers to publicly available software so anyone can view or modify the source code for their process. The Terra blockchain allows users of the platform to trade or exchange Terra stablecoins.
The underlying theme is that Terra tracks the movements of another asset, such as a fiat currency like the U.S. Dollar. Terra itself is a payment system that is built on a blockchain. It was initially developed in South Korea as Terraform Labs and established in 2018. The counterweight to Terra is Luna which allowed it to track the movements of the U.S. dollar and remain stable.
What Happened to Terra?
Unfortunately, in 2022 Terra collapsed, wiping out nearly half a trillion in U.S. dollars from the cryptocurrency market. In May of 2022, Terra experienced the equivalent of a run on the bank where depositors tried to exit after losing confidence in the token. Following the collapse of the Terra stablecoin and process, it was relaunched as Terra 2.0.
What is a Stablecoin?
Terra is a stablecoin that uses blockchain technology. The first incarnation of Terra was a stablecoin used to offer peer-to-peer lending with a value pegged to another asset. The goal of a stablecoin is to use the cryptocurrency concept but to avoid the volatility associated with cryptocurrencies.
When you evaluate the historical volatility of forex trading the dollar relative to a cryptocurrency such as Bitcoin, you can understand why a stablecoin is attractive. Historically, the dollar index experiences historical volatility ranging from 3% to 20%. Most of the time, historical volatility (see chart) for the dollar index is around 7% on average.
For comparison, bitcoin has historical volatility (see chart) that ranges from 15% to 130% and averages approximately 60%. Historical volatility is a calculation made by taking the standard deviation of a price series and dividing that by the square root of time.
A quick way to see how much that might mean an asset moves per day, you can divide that historical volatility number by the square root of a period. For example, the square root of a year (252 trading days) is approximately 16. If you take the daily move of bitcoin at an average of 60% volatility, you would see that the daily returns are about 3.75%.
This daily move compares to the daily movement of the dollar index, which is about 0.4%. This difference in daily activity makes it more attractive for someone to have a stablecoin as its base for lending and borrowing compared to 3.75% for bitcoin. As the volatility of bitcoin can be significant for trading, it is less attractive as a payment mechanism.
There are several different types of stablecoins, but all have the same premise: they track another asset’s movements. There are fiat-collateralized stablecoins that track the movements of an underlying fiat currency like the U.S. dollar. There are also precious metals back stablecoins that track the movements of gold and silver and commodities like crude oil.
Crypto-collateralized stablecoins track the movements of another cryptocurrency. There are also algorithmic stablecoins. These stablecoins might or might not hold reserve assets such as the U.S. dollar. The strategy controls the supply of the stablecoins through an algorithm that has a preset formula to reduce the volatility of the stablecoin.
Unfortunately, the algorithm does not work well in crisis which was seen with the price of TerraUSD. The coin dropped more than 60% on May 11, 2022, which eliminated the peg to the U.S. dollar, and the related token Luna fell more than 80% on the same day.
The Bottom Line
The concept of decentralized finance continues to perpetuate and has some ideas that can be helpful for those who are underbanked. The idea that consumers can use a peer-to-peer process to borrow and lend makes sense for those who do not trust the banking system or do not have access to the banking system.
In a centralized system, the finance process is overseen by a centralized institution such as a central bank or a government. The central bank then regulates banks that are part of the system. For this system to work correctly, the banks have to charge for most of their services and also have access to third parties.
Third-party vendors associated with financial institutions provide a service and charge for those services. Each link along the chain takes a fee when money is moved to a centralized financial platform, leaving the customer with the bill for the services.
Finance’s decentralization is in its early stages and is experiencing a bumpy ride. In May 2022, TerraUSD collapsed, as an old fashion run on the bank saw massive selling of the stablecoin and wiped out vast amounts of wealth.
The idea that an algorithm could predict behavior over the long term did not incorporate a run on the bank, which will likely lead to further acceleration in A.I. and asset-backed tokens that run on securities like the U.S. dollar.
A blockchain system that allows open-source software will eventually provide the necessary trust for further decentralization of finance. The issue will be to find a non-volatile product that is also decentralized which will allow for lower volatility without tracking a centralized product.