The Significance of the UST Collapse and the Growing Need for USDF
Bank-minted, tokenized deposits are the only way to ensure stability in value exchange on the blockchain with the ability to scale to support the U.S. economy.
What is UST and the significance of its collapse
What is UST and how did it work with LUNA?
TerraUSD (“UST”), a purported “stablecoin” redeemable for $1 worth of LUNA token for each UST, lost its dollar peg and collapsed last week, now hovering ~$0.10 as of this writing. Its market cap peaked at nearly $19 billion in the first week of May and has fallen to ~$1 billion as of this writing.
Exhibit 1: TerraUSD (UST) to USD chart May 8–16
Exhibit 2: TerraUSD (UST) Market Cap May 16, 2021 — May 16, 2022
UST is an algorithmic stablecoin (“algo”) in the Terra Luna ecosystem, and is collateralized by the LUNA token. LUNA is the native token of the Terra blockchain protocol, which has an ecosystem of decentralized finance (DeFi) apps. One UST is always redeemable for $1 worth of LUNA, and vice versa, 1 LUNA is always redeemable for its equivalent value of UST. The $1 pegging of UST is facilitated through the arbitraging of the supply and demand for UST and LUNA:
- For example, if UST is pricing below its $1 peg, say $0.99, one could buy one UST for $0.99 in the open market and redeem it to receive $1 worth of LUNA, which could then be sold in the open market to profit from the $0.01 difference. When UST is redeemed, it is burned (taken out of circulation) and LUNA is minted (added to circulation). The systemwide net effect is the decrease in supply of UST relative to LUNA. The buying pressure of UST and the decrease supply in UST lead to upward pricing pressure.
- Likewise, the reverse occurs when UST is pricing above its $1 peg leading to arbitrageurs buying $1 worth of LUNA in the open market and redeeming the LUNA to receive UST to then sell the UST in the open market for the higher market price. The LUNA is burned and UST is minted in this process. The systemwide net effect is the increase in supply of UST relative to LUNA. The selling pressure of UST and the increase in supply of UST lead to downward pricing pressure.
The collapse of UST — a classic bank run
UST, like other algos, do not have hard collateral and rely on market incentives to keep their peg. The problem, however, is that in times of panic, preservation of capital is the greatest and only incentive as highlighted in the following tweet by economist, Frances Coppola, speaking to the inherent instability in UST back in July 2021:
The collapse of UST and its sister token, LUNA, is the crypto poster child of a classic bank run. Certain factors set the stage for this run on UST, such as the change in the macro-economic landscape with the Fed tightening after 10+ years of easing, but UST’s relationship with the Anchor protocol (”Anchor”) likely had the largest hand in this downfall. Anchor is a DeFi protocol that acts like a money market mutual fund where UST holders can lend their UST to Anchor to receive up to a 20% APY. No, that is not a typo. Anchor actually paid up to a 20% yield on your “stablecoin.” The details of how Anchor achieves these yields for supposedly safe money goes beyond the scope of this post, but in general terms, the 20% yield was subsidized by the sale of LUNA tokens. This works when there is sufficient inflows of capital pouring into LUNA. Indeed, Exhibit 3 highlights LUNA’s market cap growth, peaking at $41 billion on April 4th before the recent collapse.
Exhibit 3: LUNA Market Cap May 18 2021 — May 18, 2022
The growth in LUNA supported the subsidy to Anchor for the ~20% yield on UST. And this was likely the driving force in UST’s market cap growth (see Exhibit 2). A recent Greyscale report noted that “approximately 70% of the UST supply was locked in Anchor.” Now THAT is a lot of hot money!
There are other factors that led to UST’s demise in the timeframe that occurred, but the seeds of fragility were already sewn, in our view. And once fear set in, the run began. Exhibit 4 plots the price of the LUNA token and the number of LUNA required to satisfy 100 UST redemption, highlighting how swift a run can be. As the LUNA price began to fall, fear set in among UST holders with increasing redemption requests for LUNA tokens in order to sell out of their UST positions. But the increasing requests meant that more LUNA was minted, thereby increasing the supply of LUNA and suppressing the LUNA price even further, leading to a vicious cycle of increasing panic and further price declines for both UST and LUNA. The rapid UST redemption requests led to hyperinflation of the LUNA token where the LUNA circulating supply increased from 340 million at the beginning of May to 6.5 trillion before the chain was halted on May 13th (see Exhibit 5). The reinforcing reflexive nature of the UST/LUNA pegging mechanism led to a quick “death spiral.” Bank runs can be swift, but the algo crypto run seen in UST is another level. LUNA did build a bitcoin reserve of ~$3 billion as a rainy day fund heading into May to protect itself from these moments, but the fund was depleted fairly quickly.
Exhibit 4: LUNA Price vs. # LUNA Required to Satisfy 100 UST Redemption May 1–15
Exhibit 5: LUNA Circulating Supply
The significance of the UST stablecoin collapse
Though there have been stablecoin failures before, the UST collapse is more significant, in our view. First, Exhibit 6 shows that both UST and LUNA are top 10 cryptocurrencies by themselves with high profile investors, and collectively would be the 6th ranked cryptocurrency as of May 1st with ~$47 billion in value.
Exhibit 6: Top 10 Cryptocurrency Market Cap Rankings as of May 1, 2022
Second, the Terra ecosystem was the third largest DeFi ecosystem, and its downfall may have repercussions, as noted in a tweet by Nic Carter of Castle Island Ventures.
Exhibit 7 shows the various startups within the ecosystem, some of which had real-world applications, like South Korean payments startup, CHAI.
Exhibit 7: Terra DeFi Ecosystem
Third, aside from being a top 10 coin with a market cap of nearly $19 billion, UST made up a meaningful part of the stablecoin market at ~10%.
But perhaps the most consequential issue from this fallout was that UST was billed as a “stablecoin.” It’s classified as a “stablecoin.” You have high-profile investors giving credibility to this “stablecoin.” This resulted in many retail investors having a false sense of security on their ~20% yielding investment. And it is perhaps this false sense of security that will catch the ire of regulators the most. Investors allocate capital according to their risk/return tolerance. When the risk is mis-represented and therefore misunderstood, capital is misallocated, which could lead to financial ruin. Unfortunately, there have been many reports of financial ruin or worse from this saga.
In his April 8th speech, acting Comptroller of the Currency, Michael Hsu noted, “If there were to be a run on stablecoins, the entire crypto economy would likely be impacted, causing outsized losses for ordinary people owning crypto and potentially leading to a host of other knock-on effects.”
It is hard to see how regulators will not act in some form given how big UST grew and how the events unfolded.
Why stablecoins are needed
Personal computers and servers ushered in a wave of efficiency through the processing power of their operating systems, and the internet allowed for these disparate, siloed systems to be connected. Blockchain technology is the next leg of this journey, offering a once in a generational opportunity that brings forward seismic improvement in how we do things by elevating the operating system to the open internet protected by the power of cryptography.
Blockchain technology offers the following distinct value propositions:
- Displacing trust with truth: Since records are immutable on a blockchain when digitally native (i.e., records are entered directly onto the blockchain) and the blockchain is open to relevant parties, there can be a single source of truth with limited need for trusted third parties for custody or attestation in many situations. The blockchain allows everyone to know in certainty that an asset is in fact what is being represented at that time.
- Real-time, bilateral settlement: By acting as a transaction ledger, custody platform, and legal ownership registry, blockchain is able to offer real-time bilateral transaction settlement by eliminating traditional intermediaries and processes. This ultimately eliminates counterparty and settlement risk.
- Composability: Businesses and ecosystems thrive when they can leverage off of existing infrastructure (i.e., not having to reinvent the wheel). Similarly, blockchain technology allows for an open loop system where developers can build off of shared resources, and in certain instances, lead to new asset classes and industries.
- Enhanced security: Because blockchain is decentralized (no one entity has control over it) and distributed (many entities have copies of it), there is no single point of attack.
- Automation: This is largely done through the use of smart contracts, which are programs stored on a blockchain that run when predetermined conditions are met. Examples of smart contract automation include credit auditing for loans, KYC/AML compliance, trade settlement procedures, loan servicing procedures, certain due diligence procedures, custodian functions, and many more.
- 24/7/365: Another key benefit of blockchain is the ability to execute transactions 24 hours a day, 7 days a week, and 365 days a year, which may ultimately push the financial exchanges into doing the same.
Much of the stablecoin activity today centers around the trading of cryptocurrencies and remittances, with trading receiving much of the media attention. However, we think blockchain technology is much more than this. The continued digitization of assets combined with the power of blockchain technology will be transformative, particularly in the traditional financial services sector (”TradFi”). The digitization of financial assets onto the blockchain has already begun. Recently, Figure Technologies, Inc. announced the transfer of ownership of eNote mortgages to Apollo through Figure’s Digital Asset Registration Technologies, Inc. (DART), a combined lien and eNote registry system used in place of the “MERS” database. Bringing financial assets “on-chain” will lead to sizable efficiencies and cost savings along with improved transparency and risk management.
And this is why “stablecoins” are needed. A stable digital asset is critical to the development and adoption of payments on the blockchain. Many forms of stablecoins have been introduced to address this problem. Today, stablecoins facilitate billions of dollars of crypto transactions and blockchain-based payments. They also unlock massive efficiencies and cost savings when used with smart contracts that transform them into programmable money, automating transactions. It’s not about the trading of cryptocurrencies. The real need centers around improving the plumbing of the financial system.
The spectrum of stablecoins and tokenized deposits
Not all stablecoins are created equally. Exhibit 8 segments the different stablecoins along a risk/stability/scalability spectrum with their distinct qualities.
Exhibit 8: Spectrum of Stablecoins and Tokenized Deposits
Algorithmic stablecoins like UST are at one end of the risk/stability/scalability spectrum. In contrast, centralized reserve-backed stablecoins like Tether and USDC pose different, but potentially significant risks, as well as questions of scalability. Despite their name, stablecoins are less stable, less scalable and riskier than bank-issued tokenized deposits. Tokenized deposits are fundamentally different from existing stablecoins, providing for the rapid settlement, low-cost structure and programmability of a stablecoin but with the regulation and protection of a bank deposit.
Tokenized deposits can be distinguished from stablecoins in one critical way. Stablecoins are digital assets that are newly created by the stablecoin issuer and are designed to have a stable value typically by being pegged to a currency or commodity. Tokenized deposits, on the other hand, are the digital representation of existing liabilities that a bank has on its balance sheet. They represent demand deposit claims against an insured bank. Importantly, tokenized deposits are obligations of banks, which are highly regulated and closely supervised by bank regulators.
When viewed in this light, tokenized deposits are a technological innovation of an already existing construct, similar to how contracts have evolved from paper formats with wet signatures to PDF formats with eSignatures. The digital contracts today still fall under the same rules and guidelines for contracts as before, but now have the benefits of technological innovation. Tokenized deposits are deposits, but in a different format.
Tokenized bank deposits are the only way to scale
If we agree that there is value to having traditional financial assets on the blockchain, and that a medium of value exchange is needed to transact on the blockchain, then where on the spectrum of stable assets is best?
First, let’s understand the total addressable market (”TAM”) that we are dealing with versus the cryptocurrency market. Exhibit 9 compares selected financial assets in the U.S. economy that could be brought on-chain versus the cryptocurrency market cap in April. The selected financial assets of nearly $200 trillion dwarfs the crypto market cap of $2 trillion by a factor of 93 times.
Exhibit 9: Selected U.S. Financial Assets vs. Cryptocurrency Market Cap
And supporting the $2 trillion crypto market is the $180 billion stablecoin market, while $18 trillion in commercial bank deposits support the U.S. economy. The $18 trillion in U.S. commercial bank deposits dwarf the stablecoin market cap by a factor of 100 times (Exhibit 10).
Exhibit 10: U.S. Commercial Bank Deposits vs. Stablecoin Market Cap
In considering which stable asset is best for value exchange on the blockchain, there are two considerations we should focus on:
- How stable is the asset for exchange?
- How scalable is the asset?
On the first question, Ethereum founder, Vitalik Buterin, noted the flaw in how stablecoins are typically judged: “…..if a stablecoin’s price stays between $0.99 and $1.01, then it’s good. That mindset is very wrong because whether a stablecoin jumps up and down by 2 percent or 0.2 percent isn’t a function of how good the stablecoin is. It’s a function of how good the market maker is and anyone can hire a good market maker for a short period of time.” The main point of stablecoins is that they need to be stable when you most need them to be stable. It’s a very fitting point in light of the collapse of UST, which held its peg very well most of the time, but could not handle periods of stress.
On the stability criteria, algorithmic stablecoins like UST would not meet the standard given their undercollateralized nature. Decentralized stablecoins like Dai are over-collateralized, but are on the riskier side of the spectrum because they are collateralized by other cryptocurrencies, like Ether, and therefore are very pro-cyclical and reflexive in nature. Centralized stablecoins and tokenized deposits are two assets of exchange that meet the stability criteria well. Centralized stablecoins like USDC are over-collateralized with non-cyclical, safe, liquid assets like cash and short-term treasuries and other high-quality, liquid assets, while tokenized deposits are the most stable, since they are governed by banking rules and regulations and are insured.
On the second question of scalability, this is where centralized stablecoins have difficulty. In order to scale to the levels needed, say 100 times to the level of commercial bank deposits, centralized stablecoins would need to tie up an enormous amount of high-quality, liquid assets, which would have serious consequences in the financial system and is not feasible, in our view. This was one of the issues noted by the Liberty Street Economics team at the Federal Reserve Bank of New York regarding centralized stablecoins.
Bank-minted, tokenized deposits are the only way to ensure stability in value exchange on the blockchain with the ability to scale to support the U.S. economy.
The USDF Consortium, which is a network of banks working to create an interoperable tokenized deposit, is bridging the gap between traditional finance and blockchain. When tokenized deposits like USDF proliferate, they will provide a truly stable and scalable mechanism for transacting on the blockchain, and they will also remove a major impediment to broad adoption of the blockchain across financial services.
STEVEN DUONG
Steven is the Director of Bank Partnerships at Figure Technologies and is focused on bringing banks into the USDF Consortium, as well as collaborating with banks on Figure’s products and services. Prior to joining Figure, Steven was a sell-side research analyst covering East Coast SMID-Cap banks. Outside of work, Steven likes to cook, mountain bike, travel, play tennis, and walk his four dogs.
