The crash in crypto markets yesterday had some unpleasant consequences. One of them was that the “stablecoin” UST no longer remained stable and lost parity with the dollar – despite the much-touted multi-billion dollar Bitcoin reserve behind it. What happened? And are algorithmic stablecoins history?
Monday started badly and developed badly. For the crypto scene, this day opened a treasure trove of atrocities, among which events surrounding the “stablecoin” UST reached an unsightly climax.
The short version: UST is an “algorithmic” stablecoin on the Terra blockchain that is backed not just by dollar reserves, but by a fabric of incentives expressed through smart contracts. The big role model for this is the Maker-DAO, which issues the DAI Dollars .
UST mastermind Do Kwon wants to outperform the DAO by making Bitcoin the “monetary standard.” He bought bitcoins for several billion dollars – probably around 3 billion – to back the stablecoins with them. According to Do Kwon, bitcoins should become an “emergency anchor” that stops a death spiral of the stablecoin, which can be triggered by an expiry of the Terra tokens (LUNA), which are mainly subject to the UST.
With 18 billion units, UST became the largest algorithmic stablecoin in the crypto markets. But the thing with the emergency anchor apparently didn’t work out as planned.
A stablecoin becomes unstable
Already on May 7, UST lost parity with the dollar. The price dropped to 99.98 cents and remained between 99.5 and 99.9 cents until yesterday. That would still be bearable.
However, in the wake of yesterday’s bloodbath in the crypto markets, the stablecoin completely collapsed. It dropped to 99.2 cents, 99.1 cents, 99.01 cents. When it finally dropped below 99 cents, the collapse accelerated. He quickly approached 90 Cent, fell under it, and then fell almost vertically. The low was 68 cents; it has since recovered, but at a good 92 cents is still far from dollar parity.
It’s not exactly stable. No other major stablecoin, neither the classic tokens USDT and USDC, nor the algorithmic stablecoin DAI, has ever lost dollar parity so sharply and for so long.
But how could that happen? Why didn’t the bitcoin emergency anchor work?
Is there any hope that UST will become more stable in the future? Or should the token – and the idea of a Bitcoin backing – be written off since yesterday? And what does this mean for other algorithmic stablecoins like the DAI dollar?
We try to answer this question at least to some extent.
When the cover melts…
First of all, UST has a structural problem: The stablecoin runs on the Terra blockchain and is backed by the native tokens of this blockchain, LUNA: You can exchange UST for LUNA, with the UST being burned. If the price of UST tilts, the idea goes, one can make a profit by destroying UST, which will solve the problem by itself. This is not that different from the DAI dollars, which are backed by Ether (ETH) and other tokens on the Ethereum blockchain.
However, while all ETH together is worth a multiple of what the almost 8 billion DAI dollars are worth (currently a good 30 times), this difference was much smaller for UST. At the beginning of May, the 18 billion UST faced Luna with a total value of about $28 billion. Even that was close.
Beginning around May 5, LUNA plummeted significantly. The price fell from $85 to just over $60. Then came bloody yesterday Monday and LUNA collapsed to a low of $25. In the course of this, the market capitalization had fallen to less than 9 billion dollars – only half as much as that of the UST. It is impossible that the LUNA tokens are still able to cover the UST stablecoins.
The Foundation steps in
Who knows what would have happened if Don Kwon hadn’t accumulated bitcoins. The “emergency anchor” grabbed. Or at least he was trying to reach out and hold onto UST.
The plan was actually to create an onchain reserve system using bitcoin instead of the LUNA tokens to back up UST. But this system had not yet been set up. Therefore, Do Kwon and the Luna Foundation had to decide and act manually.
3/ Per the LFG’s mandate, the LFG will proactively defend the stability of the $UST peg & broader Terra economy, especially under volatility and the uncertainty of macro conditions in legacy markets.
— LFG | Luna Foundation Guard (@LFG_org) May 9, 2022
The LUNA Foundation decided to lend $750 million worth of bitcoins to over-the-counter (OTC) traders to support UST dollar parity and accumulate $750 million worth of UST to use to buy bitcoins again when the market has returned to normal.
In other words: buy high, sell low, buy high, sell low. No joke.
So the $UST Bitcoin reserve strategy is to buy BTC high and sell BTC low?
Is that seriously the whole strategy?
— Chris Blec (@ChrisBlec) May 9, 2022
Of course, such a “strategy” will be exploited. Of course, the traders cash in on what the Luna Foundation puts on the market, and of course they will later sell it back to her at a higher price.
The Foundation’s reserves melted away faster than a spaghetti ice cream in the blazing July sun, partly because the prices of the contained assets collapsed, partly because it used parts of the reserves to stem the decline of UST. Of the more than $3 billion in the treasury on the morning of May 9th, by the evening of May 9th there was only… just under $200 million left. So less than 10 percent.
And the remaining assets in the Luna Foundation’s treasury aren’t particularly solid. Almost 50 percent consists of the Avalanche blockchain’s AVAX tokens, a quarter of the Luna tokens, and the rest of the “stablecoin” UST. The qualitatively most valuable assets, the bitcoins, have apparently now been completely withdrawn.
— That Martini Guy ₿ (@MartiniGuyYT) May 10, 2022
The Luna Foundation bitcoin address has a balance of 0 BTC. A good 42,000 bitcoins flowed from yesterday; a good 28,000 bitcoins were then received, but these were soon transferred again. In total, the Luna Foundation appears to have liquidated 52,000 bitcoins worth about $1.75 billion.
No wonder Bitcoin also crashed during this period. The price fell briefly to less than $30,000 last night. From there, Bitcoin recovered slightly, but is currently rather shaky at around $31,500. The volume spike that is finally visible and the absorption of this sum by buyers could be an indication that we are slowly approaching the bottom.
Why the DAI dollar is different
The incident casts a bad light on algorithmic stablecoins and their cryptocurrency backing. Without doubt. However, one should not write off the Terra Dollars or algorithmic stablecoins in general because of this. Thus, the DAI dollar held dollar parity yesterday. There wasn’t a moment when it was endangered.
A major problem with UST is weak collateralization. The total amount of LUNA tokens (only part of which is likely to cover UST when things get tight) is undervalued relative to UST. The incentives in the Terra ecosystem apparently encouraged traders to create more UST than was good, possibly because the Anchor Protocol allowed hefty interest rates of up to 20 percent a year on UST deposits. The protocol was too optimistic, the UST became unstable.
A market slump like yesterday is a crucial test for any algorithmic stablecoin. If these are backed by cryptocurrencies and their prices collapse, it will show whether the system of incentives and smart contracts is working. In the case of the DAI dollar, a series of auctions in which baskets of underlying tokens are auctioned off automatically begins. This, combined with USDC token coverage and strong over-collateralization, seems to be working well.
Do Kwon and the Luna Foundation seem to have sensed that the initial backing provided by LUNA tokens alone would be insufficient to last in the event of an emergency. Hence, they have accumulated bitcoin, with the quite attractive and interesting plan of backing a stablecoin on a small blockchain by the king of cryptocurrencies. Perhaps it would have worked if the onchain mechanisms were already in place, and perhaps their very existence would have prevented UST from slipping so extreme.
However, since such a mechanism has to work across the blockchain, it is not exactly trivial to implement. If at all, in a sensible and safe way. So the LUNA Foundation had to do it the old-fashioned way: collusion with traders, personally arranged loans, hand-signed transactions – in the centralized, cartelized, opaque, time-delayed way that blockchains are supposed to be leaving us behind.
The crash came too early for UST. Whether there is still hope for this stablecoin is uncertain. But as DAI proves, algorithmic stablecoins are inherently alive and well.