The Curious Case of UST: Algorithmic Stablecoins and Timeless Lessons from the Asian Financial Crisis

Looking at the financial headlines over the past month, it is hard not to notice the flood of news relating to unpegging of the TerraUSD (UST), freefall of its sister cryptocurrency LUNA, and their palpable impact on the selloff within the broader crypto market. The UST and LUNA crash alone wiped out $60 billion, with an estimated $400 billion evaporating from the larger crypto market due to contagion.

Stablecoin projects (majority of which emerged in 2017–18), aimed to resolve one of the key impediments to mainstream adoption of cryptocurrencies as a medium of exchange — price volatility. Some of the largest stablecoins by market capitalization today have survived not only the “crypto winter of 2018” but also the most recent cryptocurrency crash inspired by the meltdown of TerraUSD and its sister currency LUNA. These include USD Coin (USDC) and DAI at market caps of 52.3 billion and 6.3 billion (as of 26 May 2022) respectively.

With Political Science as my primary major, people around me are often surprised when I share my keen interest in finance, or when they see me preoccupied with what’s happening in the stock market, despite having Economics as my second major.

What’s a social science student doing here at a venture capital (VC) firm? And why is someone with a humanities background pivoting?

All I can say is that our interests tend to change over time, and the true value of a diversified education and exposure is how it empowers one to readily draw interdisciplinary connections.

This is one of my motivations for this article, in which I seek to elucidate the parallels between the UST crash and the Asian Financial Crisis in an easily digestible manner, whilst also sharing some takeaways that in part, have been shaped by my short time interning at Vertex Ventures Southeast Asia and India.

What are Stablecoins?

Stablecoins are digital currencies whose value are typically pegged to a more stable asset such as fiat currencies or commodities, to minimize the price volatility of crypto currencies — a key obstacle to broad based acceptance of cryptocurrencies as a medium of exchange. Assuming that a stablecoin fulfills its stated goals, it has a number of advantages over fiat, mainly pertaining to fees and speed of transfer: businesses accepting payments in stablecoins bypass the transaction fees of intermediary financial institutions, overseas workers remitting money back home can circumvent the hefty transaction fees of cross-border payments, payroll settlements need not be subject to the working hours of centralized institutions, and the list goes on.

Broadly speaking, there are Four types of stablecoins in the market:

(1) Fiat-collateralized: Stablecoins that are backed at a 1:1 ratio by fiat currency, in which owners are able to exchange their stablecoin for the underlying currency held in the coin issuer’s reserves at any time. Examples include Tether (USDT), Binance USD (BUSD) and USDC, which are USD backed stablecoins.

(2) Commodity-collateralized: Stablecoins that are backed by commodities such as gold , other precious metals, and even oil and real estate. Owners are able to exchange their stablecoin for the underlying commodity at the stipulated ratio. Examples include Digix Gold (DGX), which is backed by gold, and SwissRealCoin (SRC), which is backed by a portfolio of Swiss real estate.

(3) Crypto-collateralized: Stablecoins that are backed by other cryptocurrencies, but are often over-collateralised to absorb the fluctuations in price of the underlying asset. DAI is the most popular stablecoin in this category, and it is backed by ETH and other crypto assets.

(4) Algorithmic (non-collateralized): Stablecoins that do not have any underlying collateralized assets, but maintain their price stability through algorithms and smart contracts that manage the supply of tokens in circulation to counter price movements. Examples include DEI and Ampleforth (AMPL).

In the case of UST, it falls within the fourth category of stablecoin classification, relying on its specialized algorithm to manage the supply of tokens such that the UST is pegged to the USD at a 1:1 ratio.

How does UST Maintain its Peg?

UST maintains its 1:1 dollar peg through an algorithm that utilizes an arbitrage mechanism with its sister token LUNA. Both UST and LUNA are interlinked via the Terra blockchain, whereby LUNA is destroyed in the minting of UST and vice versa. Terra’s algorithmic market module ensures that users will always be able to exchange $1 worth of LUNA for 1 UST and vice versa.

In short, the peg is maintained by an arbitrage mechanism that is simplified in the following scenarios:

• When UST at $x > $1, traders will buy $1 worth of LUNA, sell it to mint UST, and subsequently sell UST for a profit of ($[x-1]). In the process, supply of UST increases and price falls back to $1 until arbitrage is not possible
• When UST at $y < $1, traders will buy 1 UST, sell it to mint $1 worth of LUNA, and subsequently sell LUNA for a profit of ($[1-y]). In the process, supply of UST decreases and price increases to $1 until arbitrage is not possible

Much of the demand for UST actually stems from UST tokens locked up in the Anchor Protocol — a savings, lending and borrowing platform on the Terra blockchain that incentivises savers to deposit in the lending pool with UST tokens, promising an annual percentage yield of up to 19.5%.

History Repeats Itself? Asian Financial Crisis and the UST Meltdown

The rapid unpegging of the UST to the dollar has been attributed to a concerted short attack by unknown attackers, who simultaneously withdrew significant deposits from the Anchor Protocol, dumped about $350 million worth of UST on the exchange, and further shorted Bitcoin — the crypto reserve that the Luna Foundation Guard (LFG) held as ammunition to reinstate the dollar peg in the event that UST unpegs. The large and sudden supply shock of UST, combined with the broader macroeconomic headwinds affecting the financial markets, created a “death spiral” or bank run situation in which panicking savers depositing in the anchor protocol and owners of UST withdrew their holdings at a rate that arbitrageurs could not keep up with — rapidly devaluing LUNA (as more and more LUNA are minted in the desperate bid to save the peg). With LUNA’s value approaching 0, their linkage with UST naturally means that the latter becomes of little value.

Asians familiar with economic history would see glaring similarities between the crash of UST and the tale of George Soros’ speculative attack on the Thai Baht and other Southeast Asian currencies during the Asian Financial Crisis. His famous Quantum fund sold about $1 billion worth of Thai Baht short during 1996. The Bank of Thailand exhausted large amounts of their dollar denominated reserves to purchase Thai baht on the foreign exchange markets, preventing them from reinstating the dollar peg when the crisis hit in 1997, with short sellers piling on and owners of the Thai baht indiscriminately selling them on the forex. The resulting supply shock led to the floating baht depreciating by 60% against the dollar, after it broke its dollar peg.

However, while the narratives of short sellers causing the crash of UST and the Thai baht make for captivating tales, they are merely catalysts amidst the fundamental, and structural weaknesses within the two economies. In the case of the Thai baht, it was the weaknesses of the Thai economy, while for UST, it was the Terra ecosystem.

The financial crisis in Thailand was a consequence of careless lending and borrowing which led to the accumulation of nonperforming loans. Pre-crisis Thailand was characterized by high interest rates — about 5% higher than the rest of the world. The result? It enticed not only foreign lenders to deposit their money in Thailand, but domestic borrowers also realized that they stood to gain simply by borrowing from abroad and depositing domestically. External debt doubled from $40 billion in 1992 to $80 billion in 1997, and the amount of loans tripled in the financial system. This led to careless lending that generated speculative bubbles across various sectors, with supply of loans outstripping demand by 150% in iron and steel, and by about 200% in housing, and automobiles just to name a few. Loans were channeled into already inflated assets such as real estate, where the bubble became readily apparent by 1996, with residential vacancy rates higher than 25%.

The parallel to UST cannot be clearer, with the hot money bubble largely influenced by Anchor protocol’s 19.5% APY. The decentralised finance (DeFi) lending protocol could not be self-sustained, with the borrowing interest of about 11.7% putting off many borrowers even with the added incentives for borrowers such as the right to vote in protocol proposals. The drastic over supply of loans was underlined by the low borrowing rate of 22% of all UST deposited in the protocol. To maintain the interest payment to depositors, Anchor protocol’s reserves were drained rapidly as the organic revenue generated from borrowers was insufficient to balance what it owed depositors. Sounds familiar? This was akin to the Bank of Thailand’s depletion of reserves to purchase baht on the forex markets prior to the onset of the financial crisis.

At an “economy” level, the similarities are also glaring. The founders of the Terra ecosystem set out to emulate Bitcoin in a way, as an electronic cash system (price stable money protocol) that can become a leading e-commerce stablecoin payment and DeFi service provider. However, as mentioned, about ⅔ of all UST circulation was hot money attracted by the Anchor protocol’s APY, while demand for LUNA (the other native token on the Terra blockchain) was similarly tied to UST. This mismatch of funds within the Terra ecosystem and the structural weakness due to the fundamental lack of use cases for the blockchain protocol meant that demand for UST or LUNA was non-existent when push came to shove — just like the selling pressure on the baht as the financial crisis unveiled the very real weaknesses of the national economy.

My Key Takeaways

The meltdown of the once third largest stablecoin and the largest algorithmic stablecoin in UST — with a market cap of over $30 billion just over a month ago, highlights the risk of investing in an asset with a layer 1 protocol that lacks sufficient fundamentals. However, to me, the fact that the USD backed stablecoins have retained their peg, and crypto-collateralised DAI has also remained stable implies that the problem might be specific to algorithmic stablecoins.

The underlying collaterals in these cases are tied to functioning “economies”, be it the US economy (for USDC, USDT) or the Ethereum blockchain (for DAI), similar to how the Singapore dollar remained relatively unaffected during the Asian financial crisis, as their strong economic fundamentals cemented investor confidence.

As evident from the curious case of the UST, the deep cause might actually have been “traction overrunning the fundamentals”. At Vertex Ventures Southeast Asia and India, I learnt that when it comes to investing, due diligence is king.

Focusing on building your domain expertise before investing in a particular field, and knowing when to quit when elements of your original investment thesis change, are two pieces of advice that the investment team at Vertex consistently emphasise.

Judging by the number of professional and retail investors who got burnt in this unfortunate episode, the age-old advice to “look deeply into the fundamentals, not at what is trending” ought not to be overlooked.

If you are keen to read more about crypto and analysis from a non-crypto native VC’s perspective, check out my colleagues and general partner Genping Liu’s articles on Vertex SEA’s medium.