UST Shows It’s Not Just Stablecoins at Risk of Depegging
This post was co-authored by Bob Baxley (CTO, Maverick Protocol) and Matthew Taylor (Project Manager, Maverick Protocol).
It has been almost a month since the spectacular collapse of UST and LUNA, a disaster that destroyed at least $40 billion of value in the crypto markets. Of course, three weeks is a long time in crypto, and the conversation has already begun to move on from Do Kwon, UST, and algorithmic stablecoins.
Still, this catastrophic event presents an opportunity for DeFi to examine its systems and determine the points of failure that contributed to the magnitude of the crash. It’s easy to lay the blame on the design of UST itself, but it’s also critical to recognize how the architecture of DeFi more broadly facilitated much of what followed the initial depeg.
Perhaps most importantly, the depegging of UST exposed a fundamental weakness in current AMM design: static concentrated liquidity models are not capable of protecting LPs when stablecoins lose their pegs.
As we’ll explore below, this revelation has sobering implications for more than just stable-pair stakers: it should also sound a warning bell for anyone involved in liquid staking projects.
What Happened to UST?
UST is a stablecoin, meaning it is designed to maintain a fixed value regardless of market volatility. Its value was originally pegged to the US Dollar, meaning that–if everything was functioning as intended–1 UST should generally be redeemable for 1 USD (with some allowance for minor market fluctuations). Most stablecoins maintain their peg through collateralization with other assets, but UST is an “algorithmic stablecoin,” designed to maintain its peg through the dynamic minting and burning of a secondary token, LUNA.
On May 7, 2022, over $2 billion worth of UST was drained from staking pools on the Anchor protocol, and several hundred million UST was immediately sold into the market. According to the basic rules of supply and demand, this caused the value of UST to dip to 0.91 USD, which in turn triggered a run on UST burning. Once the burning cap of $100 million was hit, UST holders began selling rather than risk a greater loss. The combined sell pressure and anxiety about redeeming UST for LUNA pushed the value of UST first below 0.50 USD, and then to 0.20 USD. At time of writing, it is currently valued at 0.034 USD.
The depegging cost LPs who provided liquidity in UST AMM pools a lot of money. As we just covered in our Maverick 101 post on Impermanent Loss, Automated Market Makers (AMMs) are designed to make trades agnostically, meaning that they don’t pay attention to market conditions and happily buy or sell assets so long as their internal prices are met by the trader.
In a regular market, any loss incurred by this design is generally limited and can be successfully offset by fees and other incentives. During the run on UST, however, AMMs facilitated the mass sell-off of UST at the expense of LPs: sellers were able to swap their UST to safer tokens, leaving LPs holding bags of rapidly devaluing UST.
The Danger of Concentrated Liquidity
If we examine real LP data from Uniswap V3’s UST/USDC pools, we can see that LPs fell victim to the fundamental danger of concentrated liquidity models, which is that they offer better pricing at the cost of high IL risk.
As a reminder, Uniswap V3 allows LPs to concentrate their liquidity in defined buckets, marked by ticks that each represent a 0.01% (1 basis point) difference in price. At the time of the UST peg-loss, the staking range in UST-USDC on Uniswap V3 was very narrow–only several basis points wide. This was rational for LPs (if they discount the risk of depegging), since they expected the bulk of trading between a stable pair to take place within a very narrow range.
Once UST depegged, however, this meant that a lot of USDC was available on Uniswap V3 to be swapped for UST at a value close to 1 USD. At this point, it would be fair to say that Uniswap V3 over-valued UST. LPs were now in a race with traders to see who could address the situation more quickly. It was a race the LPs lost, with much of the USDC getting swapped quickly for UST, creating massive IL.
It is important to note that LPs were not at fault in this scenario: they were using Uniswap V3 exactly as intended. In fact, the documentation for V3 specifically uses stable-pairs as the ideal use-case scenario for narrowly concentrated liquidity (vs. V2’s liquidity distribution).
But when the unimaginable happened and one half of a stable-pair lost its peg, the responsibility was on LPs to protect themselves from IL by moving their liquidity themselves.
Stableswapped
A similar thing happened to LPs in the Curve UST-3Pool AMM, which offers swaps between UST and three other stablecoins: USDC, USDT, and DAI. As we can see from the chart below, after the peg slipped on May 7th, LPs in the pool soon only held UST (represented as blue), as all of their USDC, USDT, and DAI was swapped out by traders. This is what maximal IL exposure looks like:
Just as with Uniswap V3, the stableswap AMM gave sellers too good of a price once the peg slipped. Even as the market value of UST plummeted, the stableswap AMM still bought it over market value, costing LPs millions.
And just like Uniswap V3, the stableswap AMM did exactly what it was designed to do: facilitate trades between stablecoins that were supposed to maintain their pegs. This AMM was built on the assumption that stablecoins would remain true to their name, and once that assumption was shattered it had no mechanism to protect its LPs from the depeg.
A Wake-up Call for Liquid Staking
The inadequacy of dominant AMM technology to handle depegging assets is not just a concern for stable-pair stakers. The relatively new world of liquid staking is built on a similar assumption that the assets involved will maintain a stable peg. In the event that the unthinkable happens a second time, liquid stakers could find themselves equally unprotected from colossal IL.
There are already signs that such a depegging could occur. In the week following the UST depeg, Lido announced on Twitter that their stETH token had depegged from ETH and was trading at a 4.2% discount in its Curve pool.
Much like a stablecoin, the idea behind stETH is that it will maintain a consistent 1:1 exchange value with ETH. Lido users stake their ETH with Lido and receive an equal amount of stETH in return, which they can put to work elsewhere while still enjoying the rewards of ETH staking. Lido calls this arrangement “liquid staking,” since users maintain a degree of liquidity while their ETH is locked in staking contracts.
A critical element of the liquid staking arrangement is users’ confidence that their stETH will eventually be redeemable for ETH. There is no way for users to withdraw their ETH from Lido directly until after the merge, and so if they want to redeem early they have to swap it for ETH on a secondary market like Curve.
Following the UST depeg, stETH holders seem to have lost some of their confidence in stETH’s redemption value, and sold enough stETH into the stETH-ETH Curve pool that the ratio between the two tokens skewed and stETH depegged from ETH. Such is the nature of markets: users feared stETH losing its peg, and their trading activity caused it to lose its peg.
Fortunately, stETH is fully collateralized with ETH and Lido has been able to take steps to stabilize the peg. But if the largest liquid staking protocol in DeFi can be shaken so dramatically, it suggests that other liquid staking projects should be looking to the security of their own investors.
If their tokens are locked in the same types of contracts used to facilitate stableswaps, they are equally exposed to IL in the event of a peg slip.
Conclusion
The events of the last month have shown us that the solutions currently used to facilitate stableswaps and liquid staking are not equipped to handle unexpected events like a depegging. The crash of UST and the shudder of stETH demonstrate the fundamental assumption that these types of assets will maintain their pegs, and the weakness of static liquidity concentration AMMs like Uniswap V3 and Curve in the event that they do not.
Both the stable-pair LP and liquidity staking worlds need a new kind of AMM technology, one that can offer stable, efficient pricing for securely pegged assets and protect investors from IL in (what used to be) the theoretical case that they lose their peg.
About Maverick Protocol
Maverick Protocol is a DeFi ecosystem that brings open, transparent, and efficient markets to everyone, powered by Maverick AMM.
Maverick AMM is an automated market maker that moves concentrated liquidity natively to achieve high capital efficiency, better prices, and effortless LPing.
Maverick AMM features an automated liquidity placement mechanism that concentrates liquidity natively and dynamically, eliminating the requirement that LPs constantly reallocate their own liquidity.
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