Post originally published Jun 7, 2022
Total capitulation of an $18 billion stablecoin, systemic risk as nearly $500 billion wiped off the total crypto market cap, Bitcoin down 25% percent in the matter of four days… just another week in crypto.
This marks the fifth major crash we’ve seen in the crypto space and the biggest capitulation since the covid crash in March 2020. But while the covid crash was a global, marketwide crash, Luna and UST has been contained to the crypto sphere.
UST is a stablecoin in the Terra ecosystem that is pegged to 1 USD. It was widely known for its too good to be true fixed yield of nearly 20%.
Stablecoins solve two very important problems in the crypto space. Firstly, they provide a bridge between volatile cryptocurrencies and fiat currencies. Secondly, and even more importantly, they provide a safe and efficient global payments infrastructure that can effectively supersede the archaic banking system.
The most widely known stablecoins on the market are USDT (Tether) and USDC (Circle). These are collateralized stablecoins, meaning that they are assumed to have enough assets backing them to promise a 1:1 redemption, even if the price dips below peg (USDT was trading below peg briefly after UST crashed but still managed to handle $7 bil in 1:1 redemptions).
Now while collateralized stablecoins may sound safer because they are backed, they betray a fundamental ethos of crypto — centralization. These institutions can effectively censor individuals by freezing their coins if they wish.
Then there’s the question of scalability. The global FX market is estimated to have a daily volume of over $6.6 trillion while stablecoins have a market cap of only $170 billion. In order to take a significant market share of that volume, an enormous amount of collateral would have to be locked up in a bank.
Which brings us to our next problem: trust.
Placing our trust in the global banking system is no issue for most people, even though we are well aware that it would not be able to withstand a bank run due to the fractional reserve system (see Greek capital controls in 2015 for example).
Stablecoins, however, are not so well established and therefore not easy to trust. We expect them to be overcollateralized so that such bank runs are impossible, which in turn leads to inefficient capital deployment. Safety over efficiency.
UST was an algorithmic stablecoin created in an attempt at crypto native base money, with the hope of solving this issue. They created a triforce of flywheels, including protocol loops through UST and Luna, on-chain loops through Mirror (synthetic stocks) and Anchor (lending and borrowing), and off-chain loops through Chai and Memepay (payment networks). If enough people adopt it, and trust it, we won’t need to worry about over-collateralization, right…?
So how an algorithmic stablecoin works is by using smart contracts to manage the supply in circulation. The particular model UST uses involves its sister coin LUNA — when UST dips below $1, UST supply is contracted and Luna is expanded to buy back the peg. When it goes above, UST is expanded and LUNA is contracted. Arbitrageurs are presented with an opportunity to restabilize the protocol by purchasing the cheaper asset and redeeming it for the more expensive one, pocketing the difference.
However, LUNA is a volatile asset. This model cannot sustain such a high yield alone without new money constantly entering (which is what is said to have saved the protocol in May 2021). There was an asset-liability mismatch — market participants are always just looking for the most efficient route to profit.
On May 7, a cascade of sell orders knocked UST off its peg, starting with an $85 mil sell order from an anonymous address that happened conveniently at the same time Terraform moves $150 mil of UST out of the 3CRV + UST pool to deploy a planned 4pool.
Low liquidity = high volatility. UST saw lows of 0.985 on the dollar that evening. LUNA also dropped by 10%, striking fear in the hearts of holders.
Hence the bank run. Imagine having $100,000 of your savings staked in Anchor at a comfy 19.5% APR when all of a sudden it’s worth $98,500. Stampede for the fire exit.
To make matters worse, as everyone was trying to redeem their UST, Terra’s chain got congested, withdrawals were suspended on multiple centralized exchanges, and collateralized positions, liquidated.
When the dust settled LUNA was down from an all time high of nearly $120 to fractions of a penny and UST was trading at approximately $0.07.
Then, as the Luna Foundation Guard sold 80,081 BTC and upward of 75k ETH to protect the peg, this cascaded into the broader crypto market as a whole.
Now if you’ve been following over the past few months, you probably saw the top signal from a mile away. It all started when an anon account on Twitter named @FreddieRaynolds was posting threads about how Luna could fail, and back in March, $22 million was escrowed in two separate bets between crypto Twitter influencers AlgodTrading, GiganticRebirth and Do Kwon, the founder of Terraform (which has since been moved to FTX for unknown reasons).
There have been several attempts at revival over the past few weeks, the most recent proposal having passed with airdrops of 30% unlocked at genesis and 70% vested over 2 years with a 6 month cliff for holders of 10k LUNA or less pre-attack. Protocols such as Astroport and Spectrum have signaled their interest to continue developing on Terra 2.0.
Now when a crypto ecosystem that’s half the size of Enron fails, regulators can’t help but take notice. Janet Yellen spoke about how stablecoins are not yet ”a real threat to financial stability” but have the potential to present further risks due to their rapid growth.
The EU has renewed its proposal for a ban on stablecoins over €2 million from Facebook’s Libra days, which is effectively coercion against any protocol’s future attempts at becoming base money.
Add this to Gary Gensler’s warning about how many other tokens will fail which will cause harm for retail investors, and we have a clear signal of regulation on the horizon.
While many like to scowl at regulators stealing our freedom, we cannot deny that some informed regulation would help, especially when customers are being misinformed about what kinds of investment products they are being sold.
tylerscharf
