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The aftermath of UST collapse

It’s been a mind-numbing 3 days. Apart from a loss of significant capital in LUNA/UST, I was shocked to read about stories of people putting their life savings into Anchor (the lending protocol). What made things worse was that people with little experience in crypto/blockchains invested in Anchor.

People reasoned that 20% returns on Anchor with seemingly no risk (stablecoin, remember) was so much better than ~0% on savings back accounts. Everyone fell for this logic, including twitter influencers, crypto experts etc (myself included). Unfortunately, some people didn’t manage their risk well & went all-in by putting all their savings into the protocol.

Here are some predictions for the next 6 months.

Before May 07'th, 15% of value held in stablecoins was truly decentralized (DAI + UST). As on May 12'th, 5% of value held in stablecoins is decentralized. Stablecoin ecosystem is a lot more centralized and this means that every Defi app is more fragile than ever.

Stablecoin space is way too centralized now (95%)

DAI is the only torchbearer of decentralized stablecoins now with $6.4 billion in circulating supply. Because DAI is extremely capital inefficient, it is difficult to scale DAI to meet the appetite of all Defi apps across multiple chains.

While every Dapp protocol markets itself as ‘decentralized’ and ‘non-custodian’, the fact that 95 % of stablecoin collateral posted on this protocols can be controlled by a centralized entity (read a large hedge fund or government/ quasi-government institution who can attack or freeze assets of these stablecoins) makes the whole Defi ecosystem fragile.

What would happen to a Aave or a Curve or dY/dX when the underlying collateral is frozen or goes to zero? Entire ecosystem can collapse under its own weight — that thought itself makes it more scary. That’s why we needed the algorithmic stablecoin experiment to succeed so badly.

As an investor, we have to attach a lot more weight to the systemic risk of stablecoin freeze or collapse — no lending, liquidity pooling, farming APY on a Defi protocol can be evaluated without looking at its USDC or USDT exposure.

Yesterday, for a few hours, we were witnessing an attack on the biggest stablecoin — USDT. For a brief period, USDT was completely de-pegged until it got back to normal levels. As a matter of fact, even 24 hours after this incident, USDT is still at 0.997 and hasn’t retained its peg completely.

De-peg of USDT (Source: CoinMarket Cap)

When I saw this, I thought the UST attackers were going after their next target, USDT. With low levels of liquidity on centralized and decentralized exchanges, playbook to attack a stablecoin seems simple.

Say you wanted to attack USDT. You need to roughly follow steps in that order:

  1. Drain liquidity of USDT from Curve pools
  2. Buy large portion of USDT in the OTC market
  3. Massively sell USDT obtained from 1) and 2) across all centralized exchanges
  4. Wait till panic sets in the market and Twitter buzz takes over
  5. Sit back and enjoy the stampede

This looks more plausible for a large institutional player with a specific agenda to destroy the Defi ecosystem. Although I’ve not done the math, I don’t think you need more than $4–5 billion to initiate an attack (as per twitter rumors, this is the amount deployed by the attacker to bring down UST Terra).

Easiest attack vector for collapsing Defi is to attack stable coins. At the current stage of evolution, stable coin attack needs pointed attacks at key liquidity sources to trigger mass panics and bank runs.

For all its chaos, UST damage was much more localized to the Terra eco-system (and maybe Avalanche, to a lesser extent) — thanks to the domination of Anchor protocol that captured $17 billion TVL (57% of all Terra TVL as per Defi Lama).

USDT on the other hand is across all chains & has a whopping $80 billion dollar in circulating supply — any attack on USDT would devastate the entire Defi/crypto space.

USDT issued across different chains (Source:Tether.to)

God forbid, an attack on USDT, would prompt people to panic exit from Defi protocols. Solana will most likely go down (based on its track record), Ethereum will suffer a heavy gas fees killing everyone with its economics. Based on past data, AVAX will also see a spike in gas fees but survive. I don’t know much about other chains but can safely guess that nobody can handle that transaction volume.

As people see USDT de-pegging further, what will start as a stream will end as a Tsunami. Such an event could be devastating for the credibility of entire L1 ecosystem. Ethereum and all Alt L1s need to significantly improve their network to face such eventuality. And do it fast..

Was it a coincidence that Janet Yellen talked about regulating stablecoins just when UST de-pegging was underway. The speed at which she responded clearly raises some eyebrows — there are already enough conspiracy theories stating that large hedge funds staged the UST attack.

Yellen promised a regulation on stablecoins by the end of this year — I believe the eventual weapon to defeat stablecoins will be Central Bank Digital Currencies (CBDC’s).

CBDC’s have a competitive advantage that no other stablecoin has — they are backed by the state which can deploy its ‘proof-of-force’ to enforce the peg. They can simply produce unlimited CBDC’s by changing a line of code in a smart contract — no proof, no audit, no reserves are needed.

Several ways in which stablecoins can be subdued are:

  1. Banning stablecoins which algorithmically mirror US dollar (not letting a better version of Terra to happen)
  2. Fractional or full-reserves to be held in CBDCs. No other collateral will be acceptable for companies minting stablecoins (This is easy to enforce on Tether (USDT) and Circle (USDC))
  3. Banning all stablecoins from exchanges except the ones holding CBDCs. Since exchanges are centralized, they have no option but to follow government rules.

In my view, the first battle for governments would be to defeat and conquer stablecoins — they know that by conquering stablecoins, they will conquer Defi.

If CBDCs dominate stablecoin market, the ‘Decentralized’ part of Defi is effectively dead & will simply end up as a ‘marketing gimmick’.

I think the final war that governments will wage will be on Bitcoin itself. Since they know that they cannot attack Bitcoin right away, they will go for the lower hanging fruit right now (stablecoin).

For Defi’s sake, I hope entrepreneurs like Do Kwon succeed in future. We need bold experiments and we need bold people to believe and execute those experiments.

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Defipi Guy

Defi investor and researcher. Macro analyst. Believe in first principles thinking. Believe in humility, open-mindedness and long term positive sum games.