The Drama As It Played

The cryptocurrency markets experienced a week of historic volatility and chaos, with the exchange rate for two stablecoins, UST and USDT keeping all crypto investors almost sleepless under enormous pressure. It’s difficult to add here any more essence on top of the plethora of earlier published stories that can be basically divided into the following categories:

  • Blaming all ‘mindless crypto maniacs’
  • Wondering how Terra’s LUNA had been tricking investors for so long
  • Questioning whether stablecoins as a whole are ‘done’
  • Calculating ‘tremendous losses’ crypto investors incurred in conjunction with Luna’s demise
  • Speculating whether Luna can cure itself and reemerge in some new form
  • Guessing “who is next”
  • Other, less obvious, considerations

Without intention to mitigate importance of finding true reason(-s) behind such a colossal blue chip token’s failure, we, nevertheless, tend not to panic and cry wolf for entire cryptocurrency industry remembering that, as we once pointed out in our previous research pieces, the entire Nasdaq is by a good third of its total market capitalization is related to companies owning or having exposure to cryptos. To assume that the crypto ‘is done’ we would also be content with the scenario of a massive Nasdaq collapse – something that could dwarf the 2000’s Dot.Com’s crisis. Only true alarmists or deep crypto haters would submit to such a calamitous scenario!

But let’s first revisit the past events. Over the course of just a few days, two top 10 digital assets by market cap (LUNA and UST) erased nearly $40 Billion in investor value. UST lost its $1 peg completely, and LUNA collapsed to a price of $0.00001 or what was referred to as becoming ‘hyper-inflated’. As a result, the Luna Foundation Guard (LFG) and the $30 billion Terra ecosystem deployed their only recently established reserves of 80,394 BTC to defend the peg, remarkably without much of success – demonstrating the fact that panic is a game-changing phenomenon across all markets, not just traditional ones.

Later in the week, and on the momentum of UST de-pegging news, the market temporarily expressed fear over the quality of Tether’s peg (USDT). USDT traded briefly down to a low of $0.9565, however recovered swiftly, currently trading at a very slight discount of $0.998. Amid the crash, UST, designed to stay pegged at $1— and associated lending protocol Anchor – bottomed out at just 13 cents.

Anchor Protocol, Terra’s high-interest savings account, has been steadily reducing the rates it offers holders for depositing UST. What began at 20% and had been marketed as “stable,” steadily began to drop following the passing of Proposal 20 back in March. That proposal meant that if Anchor’s reserves increased by 5%, the interest rate would increase. If those reserves decreased by 5%, the interest rate would also go down.

On the back of those embarrassing events, the South Korean National Assembly said it would go directly to promote a hearing to identify the situation. “As the saying goes, ‘Even if the coin price drops, the exchange still reaps the fruit of its labor”, the statement said, “so the exchanges have received close to 10 billion won in commission income only in the three days after the 10 days of the trading cessation.” “Investors’ losses are growing as legislation is delayed, ” the Korean official named Yoon said. The authorities continue to report huge losses in digital assets, and this is intolerable,” he said, “at a time when it is necessary to hold hearings as prescribed by the Congressional Act.” Yoon urged that “Relevant exchange officials, including Kwon Do-hyung of Luna, should be brought to the National Assembly to hold a hearing on the cause of the incident and investor protection measures.”

A Real Stablecoin of Just A Scheme?

The truth is that UST wasn’t backed by cash or assets like other leading stablecoins. Instead, an algorithm ties UST’s value to LUNA via a burning/minting mechanism was planned to keep UST at proximity of $1. That artificial algorithm originally let crypto holders swap 1 UST for $1 of LUNA, irrespective of the market price of both assets while destroying the UST in the process, thereby unintentionally creating an arbitrage opportunity whenever 1 UST would fall below $1, as speculators could buy the discounted UST and trade it in for $1 in LUNA, making every time a small profit. The opposite was also true: If UST traded above $1, one could swap (and burn) $1 of LUNA for the correspondingly traded UST. So, basically, the same reflexivity working in reverse, when demand fell and prices moved to the downside, created something resembling an unprotected options’ collapse when the underlying asset became apparently “out-of-the-money”. That mechanism effectively collapsed, wreaking havoc on both UST and LUNA.

The UST peg began to break on May, 9, where LUNA was trading around $60 (~49.5% off the $119 ATH). Over the next 36-hours, LUNA prices fell below $0.1, and the UST peg traded between extremes of $0.30 and $0.82. This put the protocol redemption mechanism into overdrive, as users both panicked, and arbitraged the exchange of 1 UST for $1 worth of LUNA, inflating the supply and depressing prices further.

Graph Source: Glassnode Monthly Report

So we argue that the Luna/UST collapse wasn’t caused by general failures of stablecoin pegging methodology, but rather by the ecosystem owners’ delusional idea how to bypass and simulate the vital pegging process while freeing themselves from obligation to keep adequate collateral resources. That greatly reminds the story of CDO (Collateralized Debt Obligations) collapse in 2008 that resulted in the global financial crisis and Great Recession back then. For those who still remember those events, CDOs weren’t really backed by any assets, but instead they were constructed based on expected future cash flows from mortgage borrowers, a corrupt scheme that imploded as soon as some borrowers lost their abilities to pay their monthly mortgage installments.

A Coordinated Attack?

Some people in the crypto community also keep speculating about the possibility that an individual or a group of attackers is behind Terra’s downfall.

For instance, according to Glassnode, a crypto analyst nicknamed “Onchain Wizard” with 30k+ Twitter followers, recently documented how the attack on UST could have been behind LUNA/UST downfall. The person of our interest claimed that the attacker borrowed 100,000 BTC, which were sold into LFG buying Bitcoin to fund the UST Reserve Fund. Before doing so, the attacker formed a $1 billion position in Terra’s flagship stablecoin UST.

ETH’s Creator Vitalik Buterin’s Take

Vitalik Buterin, creator of Ethereum, critiqued the entire premise of UST, citing it as, from inception, intentionally misleading and inherently flawed.

Buterin tweeted that “‘Algostable’ has become a propaganda term serving to legitimize uncollateralized stables by putting them in the same bucket as collateralized stables like RAI/DAI,”

— vitalik.eth (@VitalikButerin) May 14, 2022.

Final Considerations

Over the past few years, the market has seen stablecoins rise to represent a sizeable portion of the total market cap of all digital assets. On the 8-May, stablecoins captured more than $135 Billion in value between USDT, USDC, BUSD, DAI, and UST.

Stablecoins come in a number of skins, but can generally be represented in three types:

  • Genuinely collateralized (USDT, USDC, BUSD)
  • Crypto-over-collateralized (DAI)
  • Pseudo-Collateralized (Terra ensured investors UST was just as stable as asset-backed stablecoins).

Although this crash won’t spell the end of crypto as some critics may have hoped, it will certainly diminish the ever-growing universe of crypto ecosystems and make crypto investors more prudent and diligent at studying all analytics and other white-paper-related essentials before plunging into another crown-luring project – private investment deals and protocols trading at multiple billions without a working product.