A deep dive on “stablecoin” TerraUSD crash
To call the past week in crypto “awful” is an understatement. It has been a bloodbath: open your trading account and you’re likely to be confronted with a sea of red. But by far the biggest story of the week was the crash of stablecoin TerraUSD (UST) and the native token of the Terra blockchain LUNA. The de-pegging of TerraUSD has shaken the crypto community to its core. To help put the extent of the crash in perspective, it’s helpful to look at just how quickly and how low UST has dropped. In theory, TerraUSD should maintain a price of US$1.00. As of last week, its price is around US$0.09.
Even Web3 industry stalwarts have acknowledged the huge step backwards this represents. One of the most famed names in crypto, Vitalik Buterin, took to Twitter to voice his concern. In response to a tweet that compared algostables to Ponzi schemes he replied saying,
“That “algostable” has become a propaganda term serving to legitimize uncollateralized stables by putting them in the same bucket as collateralized stables like DAI/RAI, and we need to really emphasize that the two are very different.”
Buterin makes an important point, and as we see more and more investors entering the crypto world the difference between collateral-backed stablecoins and algorithmic stablecoins needs to be better understood. In the crypto world, where there are no Product Disclosure Statements to help consumers, it is critical that there is better education about the risks, particularly in instances where a product promotes itself as “stable” when that past week proves that TerraUSD was anything but.
The issue with TerraUSD was that in some ways it was a wolf in sheep’s clothing. It was a partially collateralised stablecoin that predominantly relied on algorithms to maintain its peg to the USD. Since early in the year Terra had been adding to collateral reserves to serve as backstop for UST. In late March Terra founder Do Kwon confirmed that more than US$1 billion had been purchased in Bitcoin to build a reserve for the stablecoin. So by that token Buterin’s commentary should be clarified, TerraUSD wasn’t solely algorithmically backed, it was also poorly collateralised.
Some market commentators are likening the crash of UST with a Lehman Brothers-like event for crypto. The subprime mortgage crisis and the repricing of mortgage-backed securities that were collateralised by bad mortgages triggered the Lehman Brothers meltdown, but the UST situation is a bit more complex. Here we break down step by step what exactly went wrong last week with UST and LUNA.
UST & LUNA algorithmic peg
The UST & LUNA algorithmic peg was beautiful in theory. The algorithm relies on price arbitrage between UST and LUNA and simple supply and demand forces. Every time a UST token was minted, or added to the circulation supply (as per the algorithm) US$1.00 equivalent of LUNA would be burned and removed from circulation. Theoretically, if UST was to rise above US$1.00, price arbitrageurs would be incentivized to burn their LUNA in exchange for UST, increasing the supply of UST. Per Economics 101, increasing supply decreases price, thus adding to the UST supply in theory would bring its price level back to US$1.00 equivalent.
So what happened?
A popular trade for UST holders was to deposit their holdings on savings protocol Anchor. The Anchor platform offered up to 20% p.a. yield on UST deposited on the platform. These yields attracted approximately 75 per cent of the entire UST supply to the Anchor platform. Prior to the crash UST deposits on Anchor started dropping. This was seemingly because not of an actual drop in Anchor’s yield offering but rather an anticipated drop – with 20 per cent p.a. rate seen as unsustainable by the market. There are few use cases for UST beyond investing in Anchor. As Anchor depositors moved their UST back into the open market, downward pressure on the UST price continued and LUNA’s price also dropped. Prior to the crash, the market cap of LUNA was far greater than UST, but this flipped and there was no longer US$1.00 worth of LUNA for every US$1.00 UST.
The Bitcoin reserve: not the saving grace it was hoped to be
Last Tuesday, in an attempt to stabilise US, the Luna Foundation Guard (LFG) that oversees the health of the Terra ecosystem deployed the BTC and other crypto reserves it had been stockpiling to purchase the embattled UST tokens in a hope that this would put upward pressure on the price. The success of this exercise was short-lived and with LFG’s reserves now depleted it looks unlikely that there is anything left in the tool kit to help save UST.
What does this meansfor crypto?
A lot of investors have lost a great deal thanks to the UST crash and with billions wiped from crypto wallets the finger-pointing has begun. US Treasury Secretary Janet Yellen has called for stablecoin regulation by the end of the year following the USDTerra collapse. And regulation may well be prudent.
Crypto is known to be a highly volatile asset class, but stablecoins promote themselves as the opposite. As the UST disaster has demonstrated the stability of stablecoins, particularly those that employ algorithmic methods of pegging, cannot be trusted. At the very least better education is necessary for investors entering the space so they are not misled by these not so stable stablecoins.