How the Crypto Crash Cost TerraUSD

Crypto critics who believe the industry is nothing more than a series of elaborate Ponzi schemes are puffing their chests today.

TerraUSD (UST), a digital token with a market capitalization of $16 billion designed to maintain a 1:1 parity with the dollar, known as a stablecoin, has plunged in the past 24 hours. Its price fell below $0.65, before recovering somewhat to $0.93 at the time of this writing. In other words, the UST failed spectacularly in the only thing it was supposed to do: maintain parity with the dollar.

The episode recalls when the Reserve Primary Fund, a money market mutual fund with $68 billion in assets, fell from $1 a share to $0.97 a share during the financial crisis after filing for Lehman Brothers balance sheet in 2008. He owned Lehman commercial paper and the collapse of the investment bank sent panic among money market fund holders who rushed to buy back shares. Money market funds were considered as safe as FDIC-insured savings accounts.

In terms of TerraUSD, the drop occurred the same day the Federal Reserve released its semi-annual report Financial Stability Report, in which stablecoins figured prominently. The report noted how stablecoins can be prone to runs on money market funds, especially during times of stress when the assets backing these tokens can become illiquid.

So what exactly happened with the UST? To begin with, it is important to note what makes the asset unique, or dangerous, in the world of stablecoins. UST is a algorithmic stablecoin, which means it works in a different way than most similar assets. More popular stablecoins, such as tether (USDT – $82 billion market cap) and USD Coin (USDC – $50 billion market cap), are backed by assets such as fiat dollars in a bank account, Treasury bills or short-term commercial debt. This approach is also dangerous because issuers have sometimes been opaque about the exact allocation of their reserves, USDT has been particularly controversial, and observers fear that these assets may not have sufficient liquid collateral to redeem the most $100 billion in assets they back. .

That said, these seem like a paragon of stability compared to UST. Instead of being backed 1:1 by tangible assets in a bank or custodian, UST uses a complicated setup with another token, LUNA, to try to maintain its peg. LUNA is a token native to the Luna blockchain, a decentralized platform like Ethereum that can run various types of applications like decentralized finance programs (trading and lending) and support non-fungible tokens (NFTs). Each UST is supposed be redeemable for $1 worth of LUNA, currently priced at $30.00

Of course, prices fluctuate like in the fiat world. The exchange rate of a dollar against other currencies adjusts daily. In the world of UST, LUNA is meant to be a stabilizing mechanism to help bring the price of UST back to $1 when it deviates. If the UST falls below $1, there would be an arbitrage opportunity to buy a UST for, say, $0.98 and then trade it for $1 of LUNA. Eventually, this trade should bring the price back into sync.

The system looks elegant on paper and a bit financially clever, but it hasn’t been proven. There have been several failed attempts in the past to create an algorithmic stablecoin. For example, about a year ago, a stablecoin IRON backup token, called TITAN, fell to zero amid market uncertainty in what the team called “the first crypto-bank operation to large scale in the world”.

It appears that Luna has been trying to learn from these failures and fears that some buyers may be worried about LUNA’s underlying value. It therefore also purchased more than $3 billion worth of Bitcoin and Avalanche as an additional stabilization mechanism for the protocol.

Last weekend, the UST began to widen from $1 as macro uncertainty continued to mount in light of Wednesday’s 50 basis point rate hike, concerns over the US data. April Inflation, released tomorrow, and double-digit declines have impacted most crypto tokens in recent days. There were allegations that an unknown actor was trying to flood the market with UST to attack the protocol, and a pseudonymous actor even took a very public $10 million short position against the asset.

While all of this was happening, over $5 billion worth of UST was being drained from Anchor Protocol, a DeFi lending application that runs on Luna. This represents about a third of the total market capitalization, which could be seen as a vote of no confidence in the asset. It had to happen at some point anyway. Participants in this protocol were receiving an unsustainable 20% return on their hold, which is abnormally high even for crypto. Eventually it was going to relax.

As you can see above, the ball of yarn started to unfold over the weekend, and even as Team Luna rolled out all the bitcoin at hand, along with hundreds of millions of dollars in UST to market makers in order to initiate liquidity. and bring things back to balance, he hasn’t recovered. It may never happen, and even if it does, the reputational damage will be nearly impossible to overcome.

If that wasn’t enough, the collateral damage was considerable. LUNA has seen its market capitalization fall from over $30 billion to $10 billion in the past five days and its price has fallen by 64% over this period. Additionally, because the team flooded the market with bitcoins in an attempt to protect the price peg, they added further selling pressure to this asset, seeing it fall below $30,000 for the first time. since last July. In total, the crypto market capitalization has lost around $300 billion in the past few days.

If there is a saving grace here, it may be that the other major stablecoins such as USDT and USDC largely managed to avoid the damage themselves. However, as they continue to grow in size, it is fair to assume that regulatory scrutiny will only grow in light of these events.

It is also fair to wonder if or when there will ever be a successful algorithmic stablecoin. UST surged largely due to backlash from crypto natives to the centralized way USDT and USDC operate, which they see as anathema to crypto ideals. Of course, decentralization is a spectrum, so perhaps there is a middle ground between purely algorithmic tokens and the decentralized model. Either way, no token will succeed until it can prove its viability in times of stress, which is what the traditional financial sector is also struggling with today.