Algorithm-Backed Stablecoin gets wrecked by Panic Speculation
Stablecoins, LUNA + TerraUSD, and a Lehman Brothers 2008 Style Crash.
TL;DR: Stablecoins are dotted line based on the US Dollar…but not really.
Hello Professionally Curious One!
I kicked off my Friday Flights with a 2nd publication, and it posts every Friday to this very same Professional Curiosity Newsletter. Check out that post here.
Moving on.
Today I’ll be talking about UST and LUNA. I previously did a research-reaction post after a Brennan W., fellow Morning Brew Accelerator Alumni teased in our slack about me having a TL;DR on it.
Not going to lie - Researching cryptocurrency trends like this is like looking at conspiracy theories. On one hand, you have technical geniuses who speak a language my feeble brain can not begin to articulate and contribute to.
On the other, you have the equivalent of that one co-worker who believes the moon landings are faked.
And then in the corner, you have someone who believes the world is runned by incredibly evolved by secret dinosaurs living in the Earth’s core.
This is all for me to say, enjoy the “Lehman Brothers” of Crypto events. You know, the company behind the 2008 subprime mortgage crisis.
As always, you can find TL;DRs and graphics where they dont need to be explaining the concepts.
In Case You Missed It
Sections You Can Skim To:
WTF is a Stablecoin?
How Does Pegging Work?
Are There Cash Reserves?
What’s Up With Luna?
Could This Have Been Prevented?
TL;DR: Cryptocurrency that derives value with a real currency so it can be stable compared to other crypto currencies.
A Stablecoin is a Cryptocurrency design to keep its value pegged to a real-world object or currency.
Here are some examples of stablecoins that are pegged to the US Dollar in a 1:1 ratio.
These cryptocoins are designed to maintain their $1 value, and can be exchanged for 1 US Dollar.
TL;DR: Hope you have some cash reserves lying around !
In an ideal world, when any currency is pegged to something else, it means that I can exchange my currency for the equivalent value of that good. An example is how US Dollar used to be exchangable directly for gold.
With USDC, Tether (USDT), and UST, these 3 stablecoins would ideally be exchangable for US Dollars at a 1:1 rate.
But buyer be warned, just because a cryptocurrency is pegged to the US Dollar, does not necessarily mean you are entitled to the US Dollar.
It’s based on the issuing institution’s cash reserve.
That’s right. I said it, institutions.
Except in this case, the institution is the company behind each coin.
This is one of those weird DeFi but not DeFi moments.
TL;DR: Yes..errr. It depends. No.
The Top Stablecoins pegged to the US Dollar
USD Coin (USDC) has a market cap of ~$50b in circulation. It is owned by by the consortium called Centre, which is founded by the company Circle and includes members from other companies.
Tether (USDT) has a market cap of ~$80b in circulation. The company behind it, iFinex Inc, only has US Dollar cash reserves of 3.87%, or $3.1b in cash. So if more than $4b in USDT is exchanged by US Dollars, this stablecoin is probably toast.
Terra USD (UST) had a market cap of ~18b in circulation. It is owned by Terraform Labs, and has no cash reserves to back the coin. Instead, it relies on algorithms to maintain its value, and uses LUNA, its sister coin, to maintain value.
Types of Stablecoins
USDC and USDT are called centralized stablecoins.
UST is called an algorithm stablecoin.
While UST is theoretically worth $1 US Dollar, it gives you no entitlement to a US Dollar even though you can trade for it. And even if you did have an entitlement, it is completely dependent on the available cash reserve, and whether there is enough supply to exchange you out.
Fun terrible fact, the same logic applies to USDC and Tether - you aren’t entitled to any of the cash reserves. But USDC has the monthly attestation of Grant Thorton, and the help of BNY Mellon and Blackrock, to maintain stability and its cash reserve.
Now that you understand the principles of Stablecoins, you are now ready to understand the story of UST, Luna, and it’s demise.
TL;DR: Algorithm-Backed Stablecoin gets wrecked by Panic Speculation
In the last 7 days, the entire crypto world witnessed the collapse of a top-performing cryptocurrency. So magnificent was the collapsed, that it went and knocked everyone else out too.
UST, which is called TerraUSD - I don’t make the rules here with the confusing names - is at the center of this story.
The TerraUSD Story
TerraUSD is an Algo-Stablecoin that maintains its value to the US Dollar in a 1:1 ratio. It’s value is pegged to it.
TerraUSD is not a centralized stablecoin, meaning it is not backed by a real world asset like gold or US Dollar.
TerraUSD is instead backed to LUNA Token, at 1:1 ratio. The Luna Token is made by the same company behind TerraUSD.
There are reserve currencies held by a Luna Foundation Guard, and that includes BTC, but these are not directly linked and are manual backings. Its best to not consider it a reserve currency.
How This Works
The algorithm between TerraUSD and LUNA mints (creates) and burns (destroys) tokens based on the demand.
The algorithm increases or reduces supply of minted tokens so that TerraUSD gets back to a $1 US Value
Changes to $0.98 cents, even $0.95 cents, to $1.01 and $1.05 cents, are expected.
In case I didn’t stress it enough, it is 100% algorithmn dependent with no direct US cash to back up the supply.
Currently (well, not really):
You can earn interest on TerraUSD by depositing it into another DeFi Product - A Savings Protocol called Anchor Protocol - which offers you 20% APY. You deposit your UST, you get 20% APY.
Of the $18b of TerraUSD in existence and in circulation, $14b is held in Anchor Protocol. Imagine $14b in a Savings Bank.
There are also other DeFi Platforms where UST can be utilized/held, but Anchor is the most significant.
The Triggering Event
What happens when $285m of TerraUSD is withdrawn (removed) in one transaction?
UST was worth $1.00 US Dollars;
Because of the $285m withdrawal, and the subsequent major withdrawals from the Anchor Protocol and other DeFi Protocols, it was suddenly worth
$0.98$0.90$0.64 US Dollars in less than a few hours.Panic withdrawals beget more panic withdrawals happened with other investors who caught win of the price change, causing them to withdraw.
This is called a bank run.
Bank Run: A bank run occurs when large groups of depositors withdraw their money from banks simultaneously based on fears that the institution will become insolvent.
And then everyone started panicking.
From $14b -> to $11b in TerraUSD
Such panic and large transactions caused the Algorithm that Stabilizes TerraUSD & Luna to ... Panic, along with everyone else.
Remember Luna Coin?
The Cryptocoin that is backing TerraUSD?
Its value was elimnated during the fall and depgging of TerraUSD.
Just how bad you ask?
Luna used to be worth $87.33 per coin. Which means $87 Luna = $87 UST = $87 US dollars.
It is now worth $0.0001903. It lost 99% in an incredibly short timespan.
The value began to drop on May 7, with the extreme fall happening on May 10.
TL;DR: Not with an attitude like Do Kwon, founder behind TerraUSD.
Here’s what the founder behind TerraUSD has to say about massive transaction withdrawals like this:
However, with that being said, the Luna Foundation Guard loaned $1.5b in reserve assets to ($750m in Bitcoin, and $750m in UST) to Market Makers to support the UST DeFi economy.
It unleashed another $1.4b subsequently after, with another $1b shortly after that, for a net total of ~$4b in bitcoin or UST reserves pushed into saving the market.
But it was too late.
And over $200b in general crypto market cap was eliminated because of the depeg.
How did this all happen?
No one knows what happened, but the loudest people on the internet claim that Citadel (Or Blackrock) caused it through tricking Do Kwan, in hopes of both shorting the drop in Bitcoin price as a result of depgging UST, and to acquire Bitcoin at a cheap price.
That’s not really provable at this time.
TL;DR: The risk of interlocked currencies, now in Crypto!
This event is basically the Lehman Brothers of Crypto, or the 2008 equivalent. While the market is sure to recover faster than ever (as is the trend with all markets these days), it does raise so many issues about Crypto.
A risk that was so perfectly encapsulated by this event, beyond the obvious founder might not be the best person, is the risk of interlocked currencies.
The downfall of UST and LUNA quite literally shocked the entire crypto market, including the incredible devaluation of Bitcoin. In this scenario, Bitcoin was used as the reserve asset.
Stablecoins hold a bridge-like intersection between Crypto and real world currency. Because of the nature of Stablecoins, and the fact that it relies on a regulated market (US Dollars in this case) to get its own value, there should be one of these types of regulations put in place:
Consumer protection similiar to a $250k FDIC Insurance so that when this happens, you aren’t literally losing all your money. There have been suicide attempts related to this.
Actual Cash Reserves, or other treasury mechanisms, to backup your stablecoin pegging.
A strict definition of a Stablecoin (Centralized vs Algorithmn vs ???) and what can be marketed as such.
As for me, will I invest in stablecoins?
Yeah.
But mostly because I’m passively earning trading fees as a Liquidity Provider and I need a stablecoin to make that work.