May 16
What Happened with the Terra LUNA Collapse and What It Means for Stable Coins Going Forwards
Note: my views. Not investment advice.
Last week over 200 billion dollars worth of crypto market cap was erased as a result of a large broad sell off of assets including equities and crypto.
The top headline was the collapse of Terra LUNA and the UST stable coin- What some are calling the largest meltdown in the history of crypto. Terra, the second largest ecosystem, with over 47 billion dollars worth of market cap wiped out in the span of less than a few days.
The spark was a massive sell off of UST into USDC, which cascaded into more sell offs, depegging UST from the dollar. As fear and contagion spread, more and more investors were looking for the exits, resulting in a massive sell off of LUNA and UST.
The protocol was forced to sell over 2 billion dollars worth of BTC collateral and mint trillions worth of LUNA token in order to attempt to maintain the UST-dollar peg, a classic hyperinflation and bank run scenario.
What is Terra LUNA?
The Luna Foundation Guard (LFG) is a non-profit organization formed to support the growth of the Terra ecosystem.
The ecosystem was headed by Do Kwon, a Stanford alumnus, and consisted of the Terra Blockchain, the LUNA token, the UST algorithmic stable coin, and other associated blockchain projects. Together, the second largest crypto ecosystem was created with UST as the reserve currency.
At its peak in 2021, the Terra ecosystem had over 40 billion dollar market cap in LUNA and UST, and approximately 2-3 billion in BTC reserves, as well as a significant amount in other blockchain related projects.
The most notable example, was the Anchor protocol, where many investors exchanged their fiat into UST and parked their assets receiving over 20% APY on their deposits.
In March, the Luna foundation announced that they would be purchasing and begin adding BTC to the Terra protocol reserves. This was a fundamentally innovative approach as it suggested using BTC as a reserve layer, much like gold was used as a reserve asset until the dollar depegged against gold in 1971.
However, massive selloffs in the crypto markets last week, coupled with fear and contagion, and a less-than-robust algorithmic stable coin protocol, contributed to UST depegging against the dollar, and LUNA becoming almost worthless in a matter of days.
This scenario is similar to what happened with Lehman Brothers in 2008, and other financial crises seen throughout the last century (currency collapses, speculative bubbles, hyperinflation, debt crises)
What are stable coins?
Stable coins are digital representations of fiat currencies and denominated as such. They are useful because they allow people to transact more seamlessly into the cryptocurrency space, acting as an on-ramp, and forming a bridge between cryptocurrencies and fiat-backed assets.
There are different types of stables coins depending upon whether they are backed by fiat, commodity, crypto, or algorithms.
Some of the top stable coins by market cap include Tether (fiat-backed, 75 billion), USDC (fiat-backed, 50 billion), and other examples including Binance, DAI, and Paxos.
These stable coins are supposed to be backed by cash, treasuries, commercial paper, and other dollar-denominated assets. All are supposed to have sufficient collateral in order to maintain a 1:1 peg with USD in the case of redemptions.
However, because these digital tokens are so new, and the regulatory landscape is not so clear, many stable coins have not undergone the same scrutiny as seen with the traditional financial system.
What is the UST stable coin?
UST is an algorithmic stable coin tied to the Terra ecosystem, which relies on an algorithm to maintain its peg to the dollar. The UST-dollar peg is maintained by either burning 1 LUNA and minting 1 UST, or vice versa, depending upon the ratio of UST to USD.
Normally, an algorithm keeps this ratio in check. However, during “black swan” events such as last week’s sell off, the algorithm wasn’t able to maintain this ratio. As a result of mass withdrawals of UST from the ecosystem, Terra had to sell off all of its BTC collateral, and print trillions of LUNA token, causing a massive price crash in BTC, Terra, and UST.
Learnings from the LUNA and UST collapse and what does this mean going forwards?
- Expect that there will be more regulation in the crypto space, particularly in regards to stable coins — Stable coins are a direct competitive threat to central bank digital currencies (CBDC) and traditional fiat currencies. Because most modern societies are moving towards a cashless digital currency regime, and because stable coins play a large potential role in this transition, regulation around stable coins will be paramount. Most recently, Janet Yellen called for stable coin regulation by the end of 2022. Most likely, algorithmic stable coins will go to the wayside, but only time will tell. In the end, I think that a proper and fair regulatory framework applied to the crypto markets that ensures that safeguards are in place, yet allowing technological advancement will be key.
- Don’t over leverage — as we can see from history, which repeats itself over and over, mass mania, fear of missing out causes speculative bubbles, over borrowing, and eventual large scale financial crises, setbacks, and financial loss.
- Take the 10 year view — crypto is a extremely nascent space. Volatility is the norm. But the volatility is what contributes to the asymmetric high risk-high reward return profile. Those who can approach crypto from a macro and long term investment framework, who are well diversified, have strong balance sheets, stick to fundamentals, and those who can focus and build during the downturn, will do well, as opposed to the short term speculators looking to get rich quick.
- The Terra LUNA UST collapse is an example of the free markets at work in real-time — Capitalism will expose weaknesses and flaws in the system. It will be up to the free markets to decide who wins and loses. Ultimately, entrepreneurs and developers will continue to learn from these lessons and make forwards progress. There will always be volatility in innovation. Venture capital involves significant risk. There will be bad actors, winners, and losers. This is the heart of capitalism. In the end, there will be no government bailouts. The best ideas, teams, and those that execute the best will win out.
About: Dr. Christopher Loo is a physician who became financially free at the age of 29, and retired early at the age of 38, as a result of making strategic investments after the 2008 financial crisis. A graduate of the MD-PhD program offered jointly through the Baylor College of Medicine and Department of Bioengineering at Rice University, he is the author of “How I Quit My Lucrative Career and Achieved Financial Freedom Using Real Estate”, and is the host of the Financial Freedom for Physicians Podcast. He is a regular contributor to KevinMD and has spoken about the importance of financial literacy for Passive Income MD, the White Coat Investor, Board Vitals, SEAK Non-Clinical Careers, SoMe Docs, Doximity, Medpage Today, FinCon, and other high-profile financial brands geared towards high-income professionals. He is passionate about the role that crypto, fintech, and innovation will play in enabling financial freedom, economic inclusion, access and opportunity for the entire world in the upcoming decades.
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