The LUNA Fiasco — Could a Regulatory Framework Prevent it?
The collapse of LUNA and its algorithmic stablecoin UST has sent shockwaves through the crypto market. But what caused the issue, could it have been prevented, and what are the implications for the future?
The recent fiasco surrounding the Terra protocol has led to an outcry amongst the crypto community and regulators alike. At the same time, it is yet unclear whether this was a coordinated attack on the network or simply a design flaw. But what happened, and could a regulatory framework have prevented the project’s fall? And maybe the most important question, what can the crypto world learn from this event?
What is Terra, and What Happened to It?
The Terra Protocol
According to Terra’s website:
“Terra is a public blockchain protocol deploying a suite of algorithmic decentralized stablecoins which underpin a thriving ecosystem that brings DeFi to the masses.”
Developed by Terraform Labs, the Terra protocol uses its native blockchain in conjunction with two main tokens, the Terra Stablecoins and LUNA.
The stablecoins of the Terra protocol are algorithmically pegged to a Fiat currency. The intention is a 1:1 price replication of a reference asset such as the USD. Luna, on the other hand, is considered the native staking token. It is being used for staking and mining rewards.
The two-token system is commonly used to absorb volatility. By paying network participants in a different native token, this secondary token absorbs the bulk trading while the stablecoin acts as a treasury asset.
Where Terra seeks to make a difference is in the way they peg their Stablecoin to Fiat. While other protocols such as Tether use the underlying Fiat currency to back their stablecoin, Terra only uses an algorithmic peg. Meaning they have no “real world” treasury assets that back their stablecoin.
In simplified terms, the protocol of Terra monitors the price of its stablecoin (e.g., UST) versus its peer, in this case USD. If the value of UST moves above or below parity, an arbitrage opportunity arises, thus incentivizing market participants to mint or burn UST until the peg is restored.
The concept seemed to work just fine. Since its launch, the Terra project propelled UST to become one of the largest stablecoins, paying highly attractive staking rates, and the LUNA price exploded to trade at all-time highs of over $115 in April 2022.
Shortly after, and within a matter of days, UST lost its USD peg, and the LUNA token plummeted, losing up to 99.9% of its value and wiping out an entire ecosystem.
What Went Wrong with LUNA?
At the time of writing it is still unclear what exactly went wrong. What is clear is that the breach of the UST to USD peg led to a spiral of decline in both native tokens of the protocol. Let’s take a look at the events in chronological order:
May 7, 2022
On May 7th, UST fell below 0.98 USD and broke its peg. Contrary to the protocol's intent, the peg does not recover for an extended period of time and as a result, UST experiences a “bank run,” where large amounts of UST are removed from protocols, further fueling the decline.
May 10, 2022
LUNA has lost 52% of its value, and UST trades 39% below its peg at $0.61.
The Luna Foundation Guard engages in countermeasures, selling 28k BTC to shore up UST in an attempt to halt the decline.
Treasury Secretary of the United States of America, Janet Yellen, refers to the UST collapse during a senate committee meeting underscoring her “concerns” about the “rapidly growing” stablecoin industry. This adds selling pressure to UST due to the concerns of impending regulations.
May 11, 2022
The selloff continues; UST is now trading at 25 cents to the dollar and sees a variety of different price listings across different exchanges leading to a spike in volume and volatility. Sellers remain victorious, and the overall downward trend continues.
LUNA is now down 95% and shows no signs of relief.
May 12, 2022
The LUNA collapse is in full swing, with the token losing up to 99.9% of its value, de-facto wiping out all existing holders. Terra CEO Do Kwon tries to reassure markets that LUNA will absorb the fall of UST and hopes that the near-worthless token will attract buyers. However, with LUNA token minting pushing supply into the trillions, a speedy price recovery seems questionable.
The Terra fiasco sends shockwaves through the crypto community, leading to a widespread price decline of cryptocurrencies. This is further fueled by economic fears from news about high inflation on a global scale, Fed tightening, and global supply chain disruptions.
May 13, 2022
Block 7607789 marks the (temporary) end of the Terra blockchain. The chain is officially halted.
The Terra developers promised to relaunch the chain but with no clear indication on when and how. However, a “post-mortem” Tweet indicates that the chain might not come back, or at least not in its previous form.
The emergency brake is pulled too late, however. At this stage, the protocol is already out of BTC and other reserves to back the UST, and the excessive inflation in LUNA tokens is causing the further demise of its value.
May 17, 2022
Apart from a few tweets circulating #TerraIsMoreThanUST, the official Twitter channel of the project has gone quiet.
The Luna Guard Foundation tweets a treasury snapshot as of May 7th but lacks to provide updated numbers that reflect sales made to back UST, which leaves the community wondering how much dry powder the foundation has left to put towards recovery and restart of the project.
May 18, 2022
Do Kwon states that “$UST peg failure is Terra’s DAO hack moment — a chance to rise up anew from the ashes.” and proposes a revival of the Terra protocol via a fork.
By this time, almost $40 billion of the protocol’s value had been wiped out.
May 20, 2022
Terra announces several amendment proposals to their protocol on Twitter. This includes changes to the liquidity parameters, token supply, and inflation mechanics.
The Aftermath & The Way Forward
Obviously, the whole unraveling of UST and LUNA did not go unnoticed in public, and it seems that overnight, newspapers, social media, and all sorts of self-proclaimed crypto specialists and critics chimed in on the discussion. On top of all that, regulators dived into the case like vultures, with Janet Yellen probably being the most prominent figure.
That leaves the question of whether some sort of regulatory framework could have prevented the implosion of the protocol or at least offered some protection of any sort.
From a financial perspective, and as the name suggests, a stablecoin has to provide price stability. Its sole purpose is the tokenization and exact replication of its underlying value, regardless of the underlying mechanism.
In the age of crypto, this is achieved through the governing code of the protocol. But since we are talking about relatively new technology, many of these concepts lack a proper track record, and only real-world application and time will show the durability of these protocols. And while other stablecoins such as USDT have weathered the Terra accident relatively unscathed, it is highly likely that they will be tested too.
Bank Runs in the Age of Crypto
As earlier explained, the Terra incident has most likely been caused by a bank run, a situation where a large number of depositors cash out and thus lead to heavy selling pressure on an asset. While bank runs are nothing new, they are an ever-existing threat to any financial framework. Some prominent examples of bank runs have led to the great depression in 1933 and brought the traditional financial system to the brink of collapse in 2008. Both events were followed by a slew of new regulations. These regulations usually target a specific event and its cause, meaning they are post-event measures to prevent the same from happening in the future. It is close to impossible to predict what could cause the next bank run, usually leaving regulators one step behind the curve.
So, could the Terra incident have been prevented by regulation? Most likely not, and it had to come to this black swan event to show the risks and limits of this, still new, technology.
How Could Regulators React, and What Does It Mean For Stablecoins?
For many regulators, it has become clear that the concept of stablecoins is the first step to digital central bank currencies (DCBC). And when we are thinking of stablecoins as a 1:1 substitute for real-world fiat currencies, we must also attribute systemic importance to them. Regardless of who issues the stablecoin, a central bank or decentralized organization. Real-world currency pegged stablecoins are de-facto a virtual application of the underlying asset.
At Inside the Block, we believe that stablecoins pegged to a fiat currency should receive a similar regulatory protection framework to the actual underlying currency. Because why should my digital dollar be less safe than a real dollar? Wouldn’t anyone ask for a risk premium for a higher-risk asset?
One theory would be that stablecoins are a high-risk asset, simply based on the yield premium over their fiat counterpart. And while some stablecoin return premiums can be justified through a more lean concept and thus less cost, it certainly does not explain all of it.
However, regulators will have to be careful when introducing regulations to stablecoins. Not only does regulation have the potential to stifle innovation, but it could lead to a situation where the central idea of speed, security, and decentralization is undermined. Traditional financial markets experienced in 2008, after which the financial landscape became a political minefield, transaction processing slowed, and entire industries struggled to comply with the new regulations for years.
So, How Much Regulation Is Needed, and Where to Start?
Here at Inside the Block, we take the view where we believe that a regulatory framework is required to ensure the future of stablecoins. A sound regulatory framework will allow for more certainty among participants and better clarity in terms of risk and risk scenarios.
Let’s outline some concepts which we believe would be beneficial for the stablecoin industry.
Transparent Treasury
Similar to existing financial institutions, asset-backed stablecoin protocols should be mandated to have a transparent treasury whereby the treasury assets are clearly defined. Providing a detailed breakdown of the treasury assets, including risk metrics of each asset, will allow for a genuine risk assessment and easy calculation of the stablecoin token value. Clear guidelines about how the treasury is managed and what measures apply in tail-event scenarios should be published by the creators of the protocol.
Furthermore, the majority of the treasury assets should be held in either the underlying currency or the nearest possible substitute. For a USD-based stablecoin, this could be actual USD, Money Market, or Treasury Bonds. Additional non-base currency assets can be permitted but have to be highlighted and a contingency plan outlining the measures in case of value decline has to be presented.
While a transparent treasury does not necessarily prevent a bank run, investors can now run a proper risk assessment, which instills confidence and trust for investors and regulators alike.
Licensing and Regulatory Oversight
Voluntary certification for audited and regulated stablecoin protocols which operate under similar reporting duties as existing financial institutions. Licensed issuers of stablecoins open the market for institutions to become part of the stablecoin ecosystem. So far, many of these institutions are prevented from using stablecoins as part of their portfolio since their regulators do not acknowledge cryptocurrencies as legally valued assets.
This would not only attract additional assets but would also provide incentives to further develop and strengthen the position of stablecoins in global financial markets.
Gating
Gating, a mechanism often used by hedge funds and private markets, basically means that only a certain amount of assets can be withdrawn at any given time. While in theory, this mechanism can prevent a bank run, the practice is often met with criticism. Many investors are not willing to only have partial or staggered access to their capital. On the other hand, the gate allows for less volatility and can be paired with incentives for investors willing to accept the policy.
A solution might be a tiering system where large investors (or whales, to use crypto terms) are subject to gates. Alternatively, one could introduce a gate only after a certain amount of assets has been withdrawn, similar to a high watermark concept.
Conclusion
While the Terra fiasco certainly was a disaster for everyone who participated in the project, these events can not be prevented. It has shown some of the limits of new technology but also sparked a necessary discussion about the future of crypto-assets and their place in the global financial system.
We are at a crucial junction where a century-old system is on the brink of being revolutionized and finally brought into the 21st century. The problem with revolutions, however, is that more often than not, they end in disaster and become victims of their very own success.
As fearful as many might be about regulation, it is not a bad thing. However, we have to be careful to find the right balance between regulation and freedom of creativity. And this is why it is vital that we forge strong collaborations between crypto communities and regulators. By deploying revolutionary technology and field testing it outside the boundaries of our existing economies, we risk the wrath of regulators, especially post failures and black swan events.
However, close collaboration and early integration of all stakeholders have the chance to substantially transform not only the financial industry but the way we interact with the global economy as a whole.
Stablecoins, whether decentralized or issued by a central bank, offer an interesting and technologically advanced way of using monetary assets. But we need to make sure they are safe to use and that everyone involved knows what they are dealing with.
A word from the author
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