Why Tron's USDD is unlikely to suffer a Terra-like death spiral

In May, one of crypto’s most popular stablecoins suffered a bank run and blew up in front of our very eyes. In just five days, the market cap of TerraUSD (UST) fell from $18.6 billion to just $1.7 billion.

You might think that would be enough to make others hesitant to endorse similar systems. Still, the team behind Tron's USDD — which had launched just days before and at the time seemed like a clone of UST — kept right on marketing to prospective investors.

Now that it's running, however, its working design appears unlikely to fail the way UST did.

USDD was one of two high-profile stablecoin projects that were designed in UST's likeness before it collapsed. These new stablecoins, like UST, were going to be “algorithmic,” meaning they would have mint and burn mechanisms — featuring a separate token — designed to keep the peg. 

They would also offer higher yields than Terra. For instance, Tron offered a 30% interest rate if users staked the USSD stablecoin, higher than the 20% yield paid out to UST stakers. The hope was that these coins could mirror UST’s success and attract similar waves of liquidity to their own ecosystems to lure in builders and speculators. 

When UST came crashing down, the other major copycat project, NEAR’s USN, pivoted away from its original design and is now effectively a collateralized stablecoin backed by tether (USDT).

The team behind USDD did not ditch the UST-like algorithmic design. But it did put major limitations on it and added a new twist. The effect is that USDD works a lot more like other established stablecoins than UST — at least for now.

Designed in UST’s likeness

Tron launched USDD just three days before UST began to collapse. When it was introduced, USDD had the same fundamental algorithmic design as UST. Just like it was possible to redeem one UST for a dollar’s worth of a separate token called luna, and vice versa, USDD holders would be able to redeem their tokens for TRX. 

During the UST debacle, it was this algorithmic component of the design that caused it to fall into what some have characterized as a “death spiral.” As UST holders rushed to mint luna during the de-pegging event, the latter’s supply exploded, causing it to lose value. This feedback loop caused luna’s supply to exponentially increase while its token price dissolved to a fraction of a cent. Within days, it was game over.

The collapse happened despite the fact that a nonprofit organization called the Luna Foundation Guard spent $3 billion trying to “defend the peg” — essentially, buying up UST in an attempt to reduce the sell pressure. That money came from a reserve of tokens, largely bitcoin, that the organization had raised in the months leading up to the meltdown. These reserves were separate from the algorithmic design and represented less than 20% of UST’s market cap. 

How USDD's reserves are different

USDD’s original design was so similar to UST’s that when USDD started slipping from its US dollar peg in June, many were concerned that it might end up being a rerun of UST’s fall.

Then in June, the team behind the Tron stablecoin changed course in a way that addressed such fears. While an updated version of the system’s whitepaper left the algorithmic aspects of the design intact, it added an important new twist: USDD would also be over-collateralized by a range of crypto assets. 

The LFG’s counterpart in the Tron ecosystem is the Tron DAO Reserve (TDR). Like the LFG had done, the TDR has also built up a war chest of tokens — specifically BTC, TRX, USDC and USDT. 

Unlike Terra's reserve, which equaled only a fifth of the total stablecoin supply, the value of Tron's reserve is greater than all of the USDD stablecoins in circulation. At the moment, USDD's market capitalization is slightly over $700 million, whereas it holds more than $2.3 billion in collateral reserves. According to TDR's website, it currently holds 990 million USDC, 140 million USDT, 10.9 billion TRX and 14,000 bitcoin. 

According to a core team member, the stablecoin is backed by excess collateral to ensure it has enough backing at all times. The TDR has said that it is raising $10 billion from blockchain industry partners for collateralized reserves.

Still, some details about how exactly USDD is working remain unclear. For instance, the project's transparency page shows that some 9 billion TRX — the same value as the total USDD in circulation — is held in a burn address. But these tokens don't appear to be actually "burned."

In crypto, the term typically refers to coins that have been sent to an address where they cannot be moved and are thus considered dead. In this case, however, the tokens are still available for use by the DAO and are controlled by a multi-sig. In other words, it appears that this TRX is part of the collateral backing the stablecoin.

So, the project has collateral behind each USDD and it additionally has a large reserve, which could either be used as collateral or spent to help the stablecoin keep its peg. Another thing the team has not been clear about, however, is whether the excess funds can be spent at will — or if they are tied to any agreements with whatever entities have handed over this cash.

Acting like a central bank

USDD still features an algorithmic mint-burn mechanism that is reminiscent of UST. The crucial difference is that only whitelisted institutions are able to participate. And according to a Tron spokesperson, though the mechanism is up and running no redemptions have been made yet.

"What USDD is doing is taking the more-traditional 1:1 collateralized approach and making it an over-collateralized protocol by introducing additional high liquidity tokens in the reserve,” the spokesperson told The Block. “However, USDD is more decentralized compared to USDT and USDC such that arbitrageurs can still participate and maintain the peg by swapping TRX within the protocol when USDD deviates from the dollar mark."

The spokesperson described the project like it was a central bank. TDR, like a central bank, will use “diversified monetary policy instruments,” they said. This includes setting the benchmark interest rate, and open market operations like buying USDD and TRX off the open market to keep the coin stable. All of this would be subsidized by the reserves. 

So while USDD is widely assumed to be an algorithmic stablecoin that works similarly to the way UST did, in practice it works much differently. Though there are UST-like algorithmic components, they are highly controlled and overshadowed by the coin's large (and somewhat mysterious) reserves. 

While at some point the algorithmic mechanism may be opened up to everyone, for now the reserves seem like the main protection against a de-pegging event. In that sense, it is more reminiscent of MakerDAO's DAI than UST. As long as it keeps working this way, it's unlikely to repeat UST's signature death spiral.