A market-based measure of stablecoin’s default probability – the case of Terra protocol

Abstract

Stablecoins have gained attention due to their rapid growth. While designed to address the high volatility of other cryptocurrencies, the collapse events of Stablecoin issuance protocols such as Terra depict that the majority of Stablecoins might not deliver the promised stability. This paper proposes a measure of the default probability of a Stablecoin issuance protocol. Utilizing a general balance sheet to mimic the capital structure of the issuance protocol, Merton model can be made fit to analyze the default risk based on the relationship between the market capitalization of the governance token and the Stablecoin. Using Terra as an illustration, the results show that the default probability for Terra is up to 81% during a market correction in mid 2021 and remained high (20%-45%) from late 2021 until it eventually collapsed in May 2022. This prediction well fits the two failure instances occurring in the Terra ecosystem. With this finding, the research serves as a cornerstone for developing enhance default risk assessment techniques in the Cryptocurrency market, opening up avenues for future studies in this emerging area.