Crypto Genius Vitalik Buterin Reveals Massive Flaw That Caused Terra's Stablecoin To Collapse

Vitalik Buterin, the co-founder of the decentralized network Ethereum, weighed in on the debate about stablecoin following the historic crash of TerraUSD and upheld the concept of algorithmic stablecoins.

In the point of view of the Ethereum co-founder, if the market activity of a stablecoin project plummets to "near zero," investors should be able to get the fair value of their liquidity. He pointed out that TerraUSD does not meet this parameter because its volcoin, which is LUNA, must keep its price and user demand to maintain its USD peg.

In the case of Terra, its stablecoin is the TerraUSD (UST) and its volatile coin or volcoin is LUNA. "In Terra, the price of the volcoin (LUNA) comes from the expectation of fees from future activity in the system. So what happens if expected future activity drops to near-zero? The market cap of the volcoin drops until it becomes quite small, relative to the stablecoin," Buterin said in a blog post.

"At that point, the system becomes extremely fragile: only a small downward shock to demand for the stablecoin could lead to the targeting mechanism printing lots of volcoins, which causes the volcoin to hyperinflate, at which point the stablecoin too loses its value," he added.

"First, the volcoin price drops. Then, the stablecoin starts to shake. The system attempts to shore up stablecoin demand by issuing more volcoins. With confidence in the system low, there are few buyers, so the volcoin price rapidly falls. Finally, once the volcoin price is near-zero, the stablecoin too collapses, the Canadian programmer said, explaining what happened to Terra between May 8 and 12.

For Buterin, it is crucial for an algorithmic stablecoin to implement a negative interest rate when monitoring "a basket of assets, a consumer price index, or some arbitrarily complex formula" that increases by 20 percent yearly. "Obviously, there is no genuine investment that can get anywhere close to 20 percent returns per year, and there is definitely no genuine investment that can keep increasing its return rate by 4 percent per year forever. But what happens if you try?” he said.

Buterin also suggested that the cryptocurrency industry should "move away from the attitude that it's okay to achieve safety by relying on endless growth." Instead, he encouraged the space to "evaluate how safe systems are by looking at their steady state, and even the pessimistic state of how they would fare under extreme conditions and ultimately whether or not they can safely wind down."

Terra's collapse has sparked a wave of fear and uncertainty across the crypto sector and it is, until now, experienced by crypto investors, who have been trading in a bearish market over the past few weeks.