What do Stablecoins and Earthquakes have in common? A prelude to disaster…
My original plan for this piece was to focus on what happened with UST. But, there are more than enough articles analyzing its dramatic downfall so I’ve decided to leave that to the other writers. So, instead, given recent events, I am going to tell you about what I see as the leading indicators presaging ‘stablecoin implosion events’. Intriguingly, I have identified some strangely similar characteristics between the incidence of Earthquakes and Stablecoin events.
In order for us to understand the underlying question here, we must first break down the concept of the stablecoin:
According to Coinbase, the definition of a stablecoin is:
“A digital currency that is pegged to a “stable” reserve asset like the U.S. dollar or gold. Stablecoins are designed to reduce volatility relative to unpegged cryptocurrencies like Bitcoin.”
How does this work? Good question. Unlike fixed-rate national currencies, stablecoin pegs like that for Tether are maintained wholly via private participants (this takes various forms, and includes the projects foundation treasury as well as arbitrage speculators); and unlike ETFs, there is no subset of private participants pre-authorized to do so. There are two key mechanisms for maintaining the peg:
- For national currencies with fixed prices, the Central Bank initiative is the mechanism: Foreign reserves are exchanged for domestic currency, adjusting supply to mute deviations from the peg
- Trades initiated by private investors that stabilize the price
And now, let’s have a run-through of the events surrounding UST in recent weeks, just so we’re all on the same page.
Here is a full breakdown of the Terra UST incident: https://news.coincu.com/90055-fall-of-terra/
For ease, here is a simple summary
May 7, 2022 - A huge amount of UST is withdrawn from the Anchor Protocol.
May 8, 2022 - That UST is sold on UST-3pool, to the tune of 285m on Binance & Curve alone
- The peg is broken, UST down to $0.99
May 9, 2022 - LFG Council votes to help UST, using a $1.5bn loan
- $750m loan of BTC to OTC firms to protect UST peg
- $750m UST to accumulate BTC as market conditions normalize
May 10, 2022 - Luna plummets, causing cascading liquidations on the protocol
- $9bn TVL withdrawn
- $10bn MCAP reduction for LUNA
- All sales of UST are people exiting the ecosystem
May 11, 2022 - Death Spiral
- LFG used all reserves to maintain the peg, but failed (~$3.5bn)
TLDR: Someone, somewhere, borrowed ~100,000 BTC and used it to annihilate the LUNA eco-system… Most likely because Do Kwon tempted them with this tweet.
What happened to UST begs the question: Can we actually rely on the stability of Stablecoins? Hoang and Baur’s (2020) assessment (How Stable Are Stablecoins?) sparked a much deeper question for me, beyond the typical post-UST paranoia we’re now in.
The reliability of Stablecoins is very much tied to their expected lower volatility. There are two core fundamental considerations when discussing volatility within this context:
- The predictability of the volatility of the asset
- The asset’s impact on other asset’s volatility
Of those two considerations, the question arises, ‘Can we actually predict the volatility of Stablecoins?’.This has been directly within the sites of the regulator for many years and one which brings so much debate and relative fear to the space. Not only in recent weeks with the implosion of a seeming ‘traditional stablecoin killer’, in Luna’s UST, but also with the ongoing grumblings which flow consistently in relation to USDT. On the second consideration, ‘The asset’s impact on other asset’s volatility’, there have been various studies on the impact of Stablecoins on the overall volatility of various assets within the Cryptocurrency market, but that is something I will be discussing on a later date.
Now we have an understanding of the stablecoin premise, we can explore a few of the burning questions we have.
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There are two types of people in the world: Those who see a problem, and those who see an opportunity. When it comes to stablecoin volatility, which side do you find yourself on?
For this part, let’s introduce 2 key concepts which will guide where you land on the above:
Victim mentality — “Someone who sees the world through a lens of good versus bad. Who considers themself to be the innocent person, and that bad things are outside of themselves”
Arbitrage — “The business of bankers which is founded on calculations of the temporary differences in the price of securities, and is carried on through a simultaneous purchase in the cheaper and sale in the dearer market.”
Previously, I discussed the two mechanisms available for maintaining a currency peg. The second, “Trades initiated by private investors that stabilize the price” is what I would like to focus on now. That mechanism suggests that not only can investors use the arbitrage methodology to their advantage to ensure a gain by capitalizing on market inefficiencies, but they can also cause inefficiencies. From an arbitrage perspective, you could very easily contend that the stablecoin is, in itself, self-regulating. The private interests of the players within the space ultimately ensure that when there is even a minor deviation, it will quickly correct back to the peg and become a non-issue, so to speak. This principle is outlined in What Keeps Stablecoins Stable? By Lyons and Viswanath-Natraj, (2021).
While that seems to clear up the main question, it also creates a new, more troubling one, which is ultimately where this piece was always headed…
If an individual, or collection of private individuals can restore the peg, the inverse is also true.
And that, in principle, is where you begin to see potential cracks in certain systems as we saw with UST, an algorithmic stablecoin that was the subject of an, evidently, extremely sophisticated attack.
Aside from the trauma that this caused the holders of LUNA and UST, many of whom were locked into staking plans, this clearly exposes the fact that the mechanism keeping the stablecoin peg can be exploited by individuals for personal gain.
The collapse of Luna was perhaps the most impactful and shocking event to happen in DeFi. But, now it’s all done, the question that I have is: can you see these events coming? Are there markers? And, do we have to accept the risks until a new, improved solution comes along?
See here a chart of UST/BUSD, which catalogs the events outlined above from the UST perspective:
Now, it is extreme, for sure, but I don’t want to focus on the implosion, I want to focus on what happened just before…
In the field of seismology, scientists study earthquake activity and monitor surface and sub-surface movements using sensors that relay data back to seismographs. When an earthquake happens, you get a phenomenon that sees that major earthquakes are preceded by several smaller ‘shudders’.
You can see an illustration here:
You can see that from the initial P-wave at 18:55:00, there is activity happening. Then, we see the recording of the S-waves, which are secondary waves that follow the emergence of the P-waves.
However, it is not until around 9 minutes later that we see the much more significant activity being registered, which would result in humans actually feeling the earthquake and taking action. It is for this reason that seismographs are placed all over the globe, monitoring for any signs of movement which could potentially cascade into much larger earthquakes.
You can see the comparison I’m drawing here… Can’t you…
Well, with UST, we had a seismograph reading… But no one took it seriously:
When we zoom in, we can see what is considered to be extremely volatile stablecoin activity, which sees what I believe to be the beginning of the assault on UST.
The approach by the attackers reminds me of the famous Sun Tzu quote, from the Art of War:
“Victorious warriors win first and then go to war, while defeated warriors go to war first and then seek to win”
I believe that Do Kwon and the Luna Foundation Guard went up against a seasoned veteran of these ‘wargames’, someone who has played them on a much larger scale, and therefore Kwon and Luna knew they were doomed before the defensive operations even began. His approach to the defense of the peg was, while honorable, it was also very revealing (in fact, too much so). He made the only elements he had in his control very public, and ultimately gave the attacker key information on the exact sum required to beat him. His war chest, the mechanism for the defense of the peg, and every intricate part of his network were readily available for assessment by anyone who had the time or inclination. With this information in hand, all the attacker needed was the capital to make it happen.
While I admit this may sound like something derived from fantasy, the reality of conflict can be seen playing out every day between the crypto space and the behemoths in the TradFi space. When you consider that billionaires will spend tens if not hundreds of millions without question to even mildly annoy their rivals, it doesn’t take much to extrapolate that to a sophisticated attack on what is a very ‘easy’ target with far too much at risk.
With that in mind, the question is: How do we limit our risk to stablecoins? Or is it even fair to say that they are uniquely high risk versus fiat currency?
The two absolutely dominant stablecoins in the market are USDT & USDC. and even they aren’t void of issues. USDT has been permanently under intense scrutiny, which has further increased following the events of UST. Whilst the mechanism they use to maintain the peg is not the same as UST, many are calling into question what reserves are being used to defend these stablecoins.
UST, for example, was extremely overexposed to BTC in its reserves. That fundamentally puts the bet on whether the peg will be secure in the same category as a directional play on BTC. What we saw was BTC going through volatility of its own, which massively reduced the $ value of those reserves, ultimately shrinking the LFG war chest before it even had a chance to begin its valiant defense.
As it stands, it seems that both USDT & USDC are primarily using US Treasuries as their primary diversifier for their reserves. That, generally, is as safe as it gets.
However, given the above charts, what do you make of the following? This chart is the USDT/USD exchange.
This is ultimately the question with stablecoins. Given that they are not a real mirror of the USD, they can only ever be a mechanism that needs unbelievable reserves to maintain the peg, especially as the market grows to $5 and $10 trillion.
As we go further back, we look at the following charts to see that we do relatively often see increased volatility for USDT specifically.
More generally, it seems to be the case that the best way to limit your portfolio risk to stablecoins is, as always, diversification. As with a traditional portfolio, you wouldn’t bet the farm on one currency being dominant, remaining dominant, and risk the currency slipping relative to others.
Now on the question of whether the intensive scrutiny is fair, I remain undecided. I believe it’s important given the nascent nature of this space, and to ensure the endless stream of new innovations coming online every day, to always scrutinize what is done, to improve things for everyone. There may be some missteps along the way, which send projects down a cul de sac, but fundamentally that is how innovation is encouraged.
Eichengreen et al pointed out in 1994 that the fundamentals of national-currency pegs include macroeconomic variables such as interest-rate misalignments, current-account deficits, government deficits, high inflation, and sufficient reserves. You can very often get situations where under sustained pressure, one of these variables can experience its own pressures and fail relative to the others. That, ultimately, causes the same issue to a fiat currency, as it would to a stablecoin. On the crypto side, the stablecoin has a similar variable-dependent flaw, such as order flow and reserves.
Although it is relatively easy to draw comparisons, it’s not particularly useful. This is because the world is entirely backed by fiat currency, whereas the same cannot be said for Stablecoins. Nevertheless, Stablecoins have overall been a hugely popular innovation as DeFi continues to develop. As a result, I’m not going to go down the route of the ‘whataboutery defense’.
To conclude, stablecoins are fundamentally required as the ‘grease’ needed to ensure a well-functioning market. There are obviously flaws in their mechanics, and we must scrutinize them best we can to expose those flaws and push for innovation. Until then, stay on high alert for the ripple that precedes the next earthquake.
Moose_22 is co-founder of Dragonfly Asset Management
DISCLAIMER: This content is for EDUCATIONAL AND ENTERTAINMENT PURPOSES ONLY and nothing contained in this blog should be construed as investment advice. Any reference to an investment’s past or potential performance is not, and should not be construed as, a recommendation or as a guarantee of any specific outcome or profit.
