The UST Collapse and its Significance for Stablecoins and Asset-Backed Tokens
Terra Luna was a project started in early 2018, and saw relentless growth over the past few years. Luna created an algorithmic stablecoin terraUSD (UST), with tokenomics connecting the stablecoin to the issuance and burning of the dynamic (aka speculative) token $LUNA. Jumping up from an unknown project to the 3rd most utilized stablecoin by 2021, UST seemed to be on a path to successfully creating a decentralized form of ‘hard money’ that would always equal a single U.S. dollar.
In the past few weeks, such illusions have been dashed. The now notorious LUNA and UST collapse saw users sell off their assets in the largest ‘bank-run’ and top-ten currency collapse in cryptocurrency history wiping $18 billion from UST as it lost its USD peg. This also crashed the price of its support coin LUNA which has now lost over 99% of its value. A revival plan by Terra founder Do Kwon has now been approved but it is yet to be seen what impact this will have for the pre-crash holders of UST and LUNA.
While these revival plans for the Terra Community may change the tide for Do Kwon and his community, it remains uncertain if people will come back to support the future of Terra.
What Caused the Collapse
Prior to the crash, Do Kwon publicly discussed that the UST peg would be defended by utilizing their Bitcoin reserves. The idea behind it was to create a reserve pool of BTC and UST assets held by the Luna Guard Foundation (LFG). Kwon stated that in this pool, whenever UST pegged higher than USD, they would sell UST and buy BTC to restore the peg. This logic worked inversely as they would have to sell BTC to push the UST price back to the USD peg.
An outside (or inside) actor noticed the flaw in this methodology and began making a sizeable exit out of UST through the Guard UST pool on Curve. The actor added $350M of UST to the pool with the least liquidity which caused the UST to start de-pegging. As it happened, LFG was forced to borrow against their BTC assets (in their words) to try to restore the peg. The group and others then proceeded to sell large amounts of UST on Binance where there were also small amounts of liquidity triggering a larger selloff. Since the peg was severely destabilized by this point, confidence was undeniably shaken leading to a massive ‘bank-run’ on UST in the form of retail trades on the platform.
As this was all unfolding, LFG was forced to liquidate part of their BTC holdings further in order to try to get the peg under control. During this gradual sell off of roughly $1.5B worth of BTC, this caused the price of Bitcoin to dip as well. It just so happens that the group involved in the attack also opened up a short position on Bitcoin that ended up profiting almost $1B by the end of the attack.
Unfortunately for folks invested in Anchor protocol, other dApps on Luna, and LUNA holders in general, this attack led to a sustained death spiral. This meant that copious amounts of LUNA were printed by the algorithm governing the stablecoin and LUNA issuance in order to try to save the UST peg while holders of UST continued to sell it on the market and take both tokens to near zero as a result. Basically everyone that borrowed on Anchor had their LUNA collateral liquidated. In addition, people that staked on LUNA validators had nothing they could do since unstaking takes 21 days, leading to one of the largest adverse events for retail in the history of finance.
Anchor was a first mover in the industry. Providing 20% APY was outrageous to some, but lasted longer than others had expected. No other company was offering such high APY for a stablecoin, and as safe as it may have seemed, it led to some great issues. Having such a significant amount in Anchor raised the question of “how will this work if everyone pulls out?” and that was exactly what happened. Even the reserves that Terra had to protect the peg would prove to not be sufficient.
Lack of Funds for a Safety Net
One of the major players that caused this depreciation of UST, happened to be the lack of funds that Terra Luna had. Having 70% of the UST supply be locked in Anchor, while the remaining 30% was the only supply left that was in accounts and so forth, created a weak spot that could be, and was, exploited by whales. These imbalances allow for the coin to be vulnerable, when holders all seek to withdraw funds simultaneously.
The main issues that stablecoins face nowadays, is whether they will have sufficient funds to defend themselves if the coin is to be attacked. After the attack, the TVL (Total Value Locked) of Anchor has depreciated from a high of $14 Million UST to $1 Million UST. These times may be rare, but as it occurred recently, it led to the troubles of UST.
The Writing was on the Wall
In a recent post by Nansen.ai, we see that the final drop that occurred on May 11, 2022 could have been forecasted through on-chain data of 7 of the top wallets staking UST in Anchor shown in the figure below. In total, roughly 2B UST was withdrawn during this time with the majority swapped for other assets once withdrawn.
From the very beginning, Terra Luna was criticized for the dependence their stablecoin placed on the Anchor protocol. Anchor was a lending and staking platform that allowed users to receive up to 20% APY from simply staking their stablecoins. Through this, about 70% of UST supply was locked inside Anchor’s protocol at the beginning of the attack. The remnants of this money was vulnerable to causing the de-pegging of this stablecoin.
Risk associated with insufficient reserve levels is not something to be taken lightly. It is the same scenario we saw in ’08 in the MBS crisis and why the majority of lending protocols in DeFi only offer overcollateralized loans. Building a global financial system must be done brick by brick and this insecurity proves the value of patience when building infrastructure. Given the nature of composability of liquidity in DeFi, it is more important than ever the mechanisms we use to evaluate risks associated with certain protocol mechanics.
The End of Algorithmic Stablecoins?
Not all Stablecoins are made equal. The figure below shows the backing of a number of different asset classes including the US dollar and B of A’s reserves to serve as comparators. Upon first glance, it is clear to see that the majority of the “value” behind a good portion of the “stable” asset liquidity today is debt. Terra (UST) stands out from the crowd with a substantial amount of negative equity in its asset backing.
Why is this? UST is minted from a seniorage mechanic. The idea proposed by Do Kwon and the Terra team was that an algorithmic stablecoin could be created for the cost of acquiring collateral. In this case, if 1 burnt LUNA worth 100 USD would mint 100 UST. The problem was that Luna itself did not have any backing to begin with and therein lies the house of cards. Luna was an algorithmic stablecoin testing the minimum amount of collateral required to back a currency. Though this test was unsuccessful, we must not throw the baby out with the bathwater.
Tokens like FEI, Frax, or DAI have different mechanics requiring greater amounts of collateral/assets prior to mint giving more substance to the liquidity in the space today.
Algorithmic stablecoins are innovative, and could continue to form part of the future of cryptocurrency. Messari analyst Dustin Teander, when asked if the collapse of UST meant the collapse of algorithmic stablecoins, told The Defiant
…it depends on how you define “algorithmic stablecoins”. If you classify algorithmic stablecoins as those with zero or less than 20% of collateral, then it’s a resounding “yes”. He clarified that he thinks models like Frax — which have high collateral factors — are here to stay.
However, the UST collapse will likely serve as a turning point in the industry. Investor trust in algorithmic stablecoins will likely be severely shaken and only those with sufficient reserve assets for protection against such events will survive. In fact it is likely this will be a requirement placed on stablecoin projects by regulators in the near future.
Response on the Hill
More comprehensive stablecoin regulation will be a likely outcome of the Terra collapse. Regulators are already using this event as a talking point to push for stricter regulation. Regulators and lawmakers are looking at the collapse of terraUSD (UST) as a question of whether esoteric products, such as algorithmic stablecoins, are safe for crypto investors, as well as whether there are broader financial stability concerns with them. U.S. Treasury Secretary Janet Yellen brought up Terra independently twice last week during separate Congressional hearings on the Financial Stability Oversight Council (FSOC).
“I think you’ve just illustrated that we just had this last week with Terra, and with tether in illustration of the risks associated with stablecoins, that there can be runs. And we’ve seen this historically with private monies, and we invented a good regulatory framework, I think for dealing with this, [we’re] going to try to solve the depository [framework],”
It is also rumored that South Korea’s parliament may seek to compel Terra creator Do Kwon to attend a hearing. The country’s law enforcement entities are also probing the collapse as a possible Ponzi or other criminal enterprise and have applied for an order freezing the assets of the Luna Foundation Guard (LFG).
Meanwhile, Kwon also faces a Civil Class Action Lawsuit brought by a major Korean Law firm on behalf of Terra and UST holders.
More Transparency Around Stablecoins
This Bill will also necessarily entail greater transparency and monitoring/reporting on the reserves held by stablecoin projects to back their coin. This will help to give consumers more security as to the stable nature of the stablecoins they choose to hold and alleviate concerns around bank runs or de-pegging.
As various governments and national agencies mobilize themselves to rapidly approach this global issue, we can only wait and see. In the United States the SEC has begun talking about the future of stablecoins, while on the other side of the world, the United Kingdom, and a spokesman from Her Majesty’s Treasury have revealed that it is open to stablecoins being used for payments. This plan may not include a regulatory approach to algorithmic stablecoins as we have known them, but it could at least provide clarity around what stablecoins are acceptable legally.
With this, transparency will be key to the success of stablecoins in the long run, and creating a set of regulations will allow for projects to not wander into the unknown when starting up. Having different outlooks on the future depends on governments, and as various countries weigh their opinions, the future will likely be determined by the larger countries who may have a bigger role in the global regulations for the crypto industry.
Looking Towards the Future
The fall of Terra (LUNA) and TerraUSD (UST) may have a noticeable short-term impact on the decision-making of both retail and institutional investors, but it doesn’t pose a risk to the larger crypto ecosystem, according to Jun Du, co-founder of Huobi Global.
When asked about critics who are using the Terra collapse as an opportunity to take a dig at the entire crypto market, Du highlighted that crashes like Terra also happen in many other industries.
“Market crashes and coordinated attacks are not unique to crypto,” said Du. Citing the Lehman Brothers collapse and the housing market crash, Du mentioned that “every industry will see its fair share of toppled players… Crypto as a technology and asset class introduces value and innovation that are unique and irreplaceable, and we believe that one bad apple in the short run will not affect long-term demand for crypto assets and the industry as a whole.”
The bipartisan Senate cryptocurrencies bill sponsored by Wyoming Republican Cynthia Lummis and New York Democrat Kirsten Gillibrand is seen as having a better chance of becoming law than many other crypto bills introduced so far.
The senators say TerraUSD’s collapse underscores the need for the regulatory framework they plan to propose.
The Lummis/Gillibrand Bill places stablecoins under the Office of the Comptroller of the Currency (OCC). However, it stops short of proposing to regulate stablecoins as if they were banks.
“The Senators didn’t want the same regulations for banks to stablecoins, which would limit the market. Rather, they want to offer flexibility to enable innovation. While the new approach does not require any deposit insurance, the stablecoins need to maintain fully-backed reserves of 100% at all times.”
What is not stated here, is whether those reserves will be required to be held as USD, however indications are that this is highly likely. In that case, algorithmic stablecoin experiments such as UST backed by Bitcoin and other crypto assets may face serious threats to their existence.
Bringing Standards to a Nascent Market
Standard brings back the idea that crypto should be something truly valuable, whether that be as plumbing for a network (e.g., Ethereum) or a transparent representation of real world value (e.g., asset backed tokens). Core to this infrastructure, the strategies behind Standard are those that create value for its community and the broader crypto market rather than extract it. With that, there are some key areas of difference to point out between Standard and Terra.
- Standard is backed by a basket of assets
- SDA token is only created when value comes into the treasury (i.e., value in=value out)
- SDA is not a stablecoin
SDA tokens hold their value through a treasury of backing made up of a diversified bundle of real world and digital assets. These assets will include real estate, gold, cash, renewables, and other precious metals as well as infrastructure based digital assets. The treasury will be sufficiently diversified between asset classes reducing risk of a singular attack vector.
SDA does not rely on an algorithm to keep pricing above a stable level and will have more than just money from a liquidity pool as Terra did to defend it from sell-offs and volatile periods. Holding a basket of performing assets to back the SDA tokens will provide a more solidified intrinsic valuation, something that the general market of cryptocurrencies have yet to address.
The Last Defense Against Hyperinflation (It’s Only Transitory…)
While real-world assets will back the SDA token, the mechanism of it as a whole will be different than what was seen with Terra Luna. Every time that LUNA was bought, some UST was burned, or vice versa. The mechanism that Terra had was hyper-inflating, and now after the coin has become worthless, there are still well over 6 trillion LUNA coins floating around, at a worthless price.
Standard takes a different approach, and while it is not a stablecoin, it holds an intrinsic value of backing for each token equal to at least 1 DAI in value. The goal of SDA is to continue to grow its intrinsic value for each token above the value of 1 DAI through revenues from treasury assets and other business activities within the DAO.
A key component of the thesis behind Standard is the promotion of value creation behaviors solidifying that a successful rollout will be continued growth of intrinsic value backing each token created over time.
Free Float, Not Free Fallin’
SDA token differentiates itself from stablecoins since the price is a free float around the intrinsic value rather than being pegged to a certain price. The token price will be determined by the market while the value will rely largely upon the actions of the DAO and community, leading to greater accountability around the activities Standard pursues.
A recent tweet thread around DAO governance by Graham Novak highlights the benefits of a DAO by providing accountability, and being permissionless and ultimately verifiable.
The Bottom Line
While so many innocent people were derailed by this Terra Luna death spiral, it is important for us as a community to learn and understand what we can do better so that people can engage with these financial products/applications with greater confidence. Here at StandardDAO, our model is built to ensure that our protocol is not thriving for just one bull market but for generations to come. With real world backing, people first initiatives, and built-in circular economies, we look forward to the change that we can achieve, together.