Crypto mythologies with Kitsune — Send It Ep. 17
Death of an algorithmic stablecoin — lessons from the LUNA meltdown
On May 9, the supposed-stablecoin UST violently broke from its $1 peg. Efforts to restore the price to its target against a “bank run” to the exits resulted in uncharacteristic volatility for what many heralded as the most successful algorithmic stablecoin yet. LUNA — the native crypto asset of the Terra blockchain and part of UST’s price-stability mechanism — quickly followed, cascading downward to fractions of a cent as its supply hyperinflated.
Despite efforts by the Luna Foundation Guard and Terraform Labs to restore the peg, the slide continued throughout the week beginning May 8 before Terra validators halted the blockchain on May 12. The cost of acquiring a majority share of the proof-of-stake network’s native tokens had plunged to levels that made economic attacks trivial.
The LUNA meltdown has been brutal to watch, and many investors sold on the ecosystem’s questionable stablecoin’s attractive interest rates have lost absolutely everything. The week beginning May 8 has been one of crypto’s bleakest. But what brought about the UST death spiral, and what will its impact be going forward?
In this OKX Insights in-depth, we put the Terra ecosystem under the spotlight.
- UST and LUNA crashed to levels thought impossible by investors.
- The index prices for both UST and LUNA hit all-time lows of $0.04495199 and $0.000000999967, respectively.
- It’s unclear if the crash was caused by a deliberate attack or by the system’s inherent inability to protect itself from a sudden influx of sell pressure.
- Luna Foundation Guard’s efforts to restore the peg using BTC reserves failed.
- Terra validators had halted the blockchain as the plunging LUNA price put it at risk of economic attack.
- Retail traders and investment funds are both heavily impacted, sucking much of whatever optimism remained from the industry.
- Regulators are now eyeing the crypto industry closer than ever, with a harsh clampdown on stablecoins increasingly likely.
What’s going on with LUNA and Terra?
LUNA and its related stablecoin, TerraUSD — also known by its ticker, UST — had been a gift for many investors hurting from cascading prices across major crypto assets since late 2021. While the combined crypto market’s slide tortured traders — bleeding from over $3 trillion in November to around $1.7 trillion on May 7 — LUNA enjoyed a run from below $50 to just shy of $120. At the same time, a decentralized-finance protocol deployed on the Terra network, Anchor, was paying UST depositors 19.5% APY on UST.
With bearishness in the broader market setting in and a DApp offering attractive, “guaranteed” yields, it’s unsurprising that UST’s market capitalization rose essentially unchecked from $2.9 billion in November 2021 to $18.7 billion just before its downward spiral began in May. The run was kickstarted on Nov. 10, 2021, by the passing of a governance proposal to burn around 88.7 million LUNA in order to then mint around 4 billion UST.
Further fuel was added in February when Singapore nonprofit Luna Foundation Guard, or LFG, announced the creation of a $10 billion BTC reserve fund to help reinforce the peg during market volatility. The LFG later laid out plans for a similar reinforcement initiative utilizing the Avalanche network’s native asset, AVAX. Before the recent LUNA crash, LFG had acquired around $3.5 billion in BTC.
A recap of the Terra ecosystem
To appreciate why both LUNA and UST crashed so violently and shook the entire crypto market, it’s essential to understand the different actors involved. Terra, the network, is part of the wider Cosmos ecosystem. LUNA is Terra’s native crypto asset and, like most, is volatile, with its price floating according to supply and demand.
The network also supports a family of native algorithmic stablecoins, of which UST is the most prominent. Unlike collateralized stablecoins like USDT or USDC, there is absolutely nothing backing UST. Instead, the protocol incentivizes market participants to keep the peg.
The protocol always values $1 worth of LUNA as 1 UST, regardless of either asset’s current market price. When demand for UST outweighs supply, and its market price is above $1, arbitrageurs can mint UST by burning an equivalent amount of LUNA, selling it immediately for a profit and putting downward pressure on the price.
For example, with LUNA priced at $100 and UST at $1.01, burning 1 LUNA mints 100 UST, which can then be sold for $101. When enough participants take this arbitrage, the price should return to the peg.
If the UST price falls below $1, arbitrageurs burning UST receive an equivalent value of LUNA. This reduces the circulating supply, which brings the price back to the peg, providing there is demand for UST. For example, with LUNA priced at $100 and UST at $0.99, burning 100 UST mints 1 LUNA but only costs $99 to acquire.
Algorithmic stablecoins can maintain their peg more effectively when demand increases and their overall market cap rises. When selling pressure outweighs buying, it’s far more challenging to maintain the peg — and, if confidence in the stablecoin wanes, there is a risk of a so-called death spiral.
For “lunatics” — the name assumed by fans of the Terra ecosystem — UST would succeed where other algo-stablecoins had failed because it has a built-in source of demand. Unlike most stablecoins, UST is native to a blockchain, which is host to an emerging decentralized finance ecosystem. Like other DeFi ecosystems, Terra experienced voracious growth during 2021; however, contrary to the rest of the crypto market, its upward trend continued into 2022 — following a brief pullback — creating plenty of demand for UST.
Central to Terra’s DeFi ecosystem and the driving force behind UST-demand growth was Anchor, a Terra-based decentralized lending protocol similar to Aave on Ethereum. It provides a rare-for-DeFi “fixed income” of almost 20% on UST deposits and claims to achieve this by staking deposited assets on other L1s. Yields are kept consistent using a reserve system and borrowing incentives.
Clearly aware of the death-spiral risk, LFG added non-Terra assets to a reserve fund earlier this year. The idea was to exchange BTC and AVAX held in the treasury for UST to restore the peg if the UST price ever fell to $0.98 or less.
It figures that Terra cofounder Do Kwon would be familiar with the concept of a death spiral as, amid the recent carnage, it emerged that he previously launched the failed stablecoin Basis Cash under the pseudonym Rick Sanchez. Basis Cash performed spectacularly poorly, even for an algo-stablecoin.
What rocked the UST peg?
In early April, a new stablecoin liquidity pool was announced on the Curve decentralized exchange. Known as 4pool, it would hold UST, FRAX, USDC and USDT deposits. As a post to Terra’s governance and proposal forum explains, the idea behind 4pool was to win the so-called Curve Wars.
Together, FRAX and UST would hold enough of the protocol’s governance tokens to increase emissions paid to the pool’s liquidity providers. By making it “the most liquid and utilized stablepool,” 4pool would enable “the entire DeFi industry to transition to greater usage of decentralized stablecoins.”
The 4pool went live on Ethereum on May 4. As part of its launch, $150 million in UST was removed from the previously dominant UST-3pool containing USDC, USDT, DAI and UST on May 8 ahead of its deployment in 4pool. With the pool’s liquidity reduced, a sudden 85 million UST sell into the pool drained its USDC liquidity, sending the UST price below a dollar and sowing the seeds for a death spiral of epic proportions.
The UST price dropped to $0.99, where it remained over the weekend. Two addresses attempted to restore the pool’s balance by depositing non-UST stablecoins into 3pool — bringing the UST price up but not fully restoring the peg.
The general bearish sentiment in the crypto markets exacerbated the concern surrounding UST’s stability — but full-scale panic had not yet set in. When UST fell again to $0.98 the following day, LFG announced the deployment of $750 million worth of reserve BTC.
Around the same time, colossal UST sells occurred on centralized exchanges, putting even greater pressure on the peg as LFG attempted to restore it with UST buys made with funds from selling BTC. With confidence rocked and the peg breaking, shorters joined those rushing for the exits. This resulted in perhaps the most significant and fastest crash in any crypto asset’s history.
Congestion on the Terra blockchain only exacerbated the panic, and withdrawals poured out from Anchor as investors rushed for the exits. Money had already started leaving Anchor before the incident but not in the volume that would come later. The cause was likely twofold: the reduction of “guaranteed yield” from 19.5% to 18% and similar algo-stablecoins on networks like TRON offering a more attractive APY.
Was it an attack?
Theories abound that the meltdown was prompted by a coordinated attack, with suspected participants including Gemini, BlackRock and Citadel — each of which quickly denied any involvement. Yet, several observers have highlighted the timing of events as being suspicious.
For example, the 85 million UST sell into 3pool came around 10 minutes after funds were removed from the pool. The pool’s reduced liquidity meant it would take considerably less capital to move the UST price and prompt investor doubt.
The theory goes — and remember, it is only a theory — that an attacker borrowed 100,000 BTC and simultaneously built a $1 billion UST position with OTC buys. This gave them the capital to drain the 3pool, creating uncertainty over UST’s stability. Knowing that LFG was accumulating BTC, the supposed attacker sold their BTC, creating a substantial short position.
As the UST price shook from the liquidity drain and the beginnings of panic, LFG would be forced to sell its BTC holdings to bring the stablecoin back to its peg. The supposed attacker’s short now in profit, they could begin selling the remaining 650 million UST on centralized exchanges, where they may have also opened short positions to lock in even more profit. This sudden selling pressure caused the UST price to drop further, creating more panic, and investors fled in typical “bank run” fashion.
Amid the chaos, Do Kwon announced a UST “recovery plan” was in the works on May 10. Rumors began circulating that LFG hoped to raise more than $1 billion to restore the peg by selling discounted LUNA with a one-year lockup period. Periods of silence from Do Kwon, followed by a May 11 tweet confirming that the plan was still not ready, fueled the shift from concern to all-out panic.
On May 12, it became clear that a bailout was not coming. Do Kwon’s next tweet would seal LUNA’s fate.
Essentially, Do Kwon confirmed that LUNA’s price would be forced to absorb all the UST held by the many who had lost confidence in the protocol — after all, this is how the system is designed to work. He added that the LFG supported a governance proposal to increase LUNA’s minting capacity to $1.2 billion, which would speed the asset’s downward spiral considerably while absolutely nuking the LUNA price.
With LFG’s BTC backstop depleted to a then-unknown level, confidence in UST plunged, as evidenced by its cascading price as holders rushed for the exits. Traders withdrew UST from Anchor and exchanged it for newly minted LUNA, which quickly flooded the market.
Figures from analytics site Messari show LUNA’s circulating supply rose from less than 345 million on May 7 to around 6.53 trillion on May 13. The LUNA price, of course, suffered, falling to fractions of a cent.
LUNA’s rapidly depreciating value also put the Terra protocol itself at risk of attack. As a proof-of-stake blockchain, the cost of obtaining more than half of the tokens staked is the cost to attack the network. Having shed more than 99.9% of its value, acquiring a majority share of the total staked is now much cheaper than it ever has been.
As a preemptive measure, Terra validators announced that they would halt the network on May 12. After multiple pauses, it was brought back online the following day. On May 13, Do Kwon posted a “Terra Ecosystem Revival Plan” to the Terra governance forum. The plan proposes forking the chain to reduce the number of circulating LUNA to 1 billion. In the post, Do Kwon also ceded UST’s defeat:
“Even if the peg were to eventually restore after the last marginal buyers and sellers have capitulated, the holders of Luna have so severely been liquidated and diluted that we will lack the ecosystem to build back up from the ashes. While a decentralized economy does need decentralized money, UST has lost too much trust with its users to play the role.”
Do Kwon’s revival plan is not the only option being discussed at present. Terra’s governance forum features other posts suggesting ways to move forward. As per his most recent Twitter thread, Do Kwon’s focus seems to be preserving the Terra community in whatever way possible — how this will unfold remains to be seen:
“What we should look to preserve now is the community and developers that make Terra’s blockspace valuable — I’m sure our community will form consensus around the best path forward for itself, and find a way to rise again.”
The only thing that is clear is that Terraform Labs has fully abandoned the idea of an algorithmic stablecoin. A May 11 Twitter thread from Do Kwon revealed that UST would be rebuilt as a collateralized model.
In an investor note shared with OKX Insights, Nevin Freeman, cofounder of Reserve — the protocol behind the fully collateralized stablecoin RSV — explains why algorithmic stablecoins are fundamentally flawed. Referring to LUNA as “shares” and UST as “coins,” he writes:
“If share holders panic and sell all at once, share price can drop quickly. At some point, coin holders will start to see that the shares they can redeem their coins for may not end up being worth anything. At this point, the coin holders also start to rush for the exit, trading into shares as fast as they can, and dumping those shares immediately. Among stablecoin geeks, this is called the ‘death spiral.’ Unless some external buyer steps in to buy back all the coins for some reason, it’s probably irrecoverable.”
Indeed, many observers had warned of such a risk in the Terra ecosystem. However, they were routinely shouted down by an increasingly arrogant Do Kwon and his following of increasingly fanatical “lunatics.”
Observers were left guessing the whereabouts of LFG’s remaining BTC reserves over the weekend. The foundation’s dashboard reported holdings of less than $80 million as of May 14. For perspective, the total balance was just over $4 billion on May 3.
Following a tense weekend of silence, LFG revealed Monday that it had used far more of the total reserves “in a last-ditch effort to defend the peg” than initially reported. In a thread, the foundation stated that it had converted most of its assets to UST to stop the bleeding, leaving around 313 BTC, 40,000 BNB, 2 million AVAX, 1.8 million UST and 222 million of mostly staked LUNA. The new total reserve is approximately $84 million — a fraction of its former balance.
The Twitter thread also states that LFG will use the remaining assets to compensate the remaining UST holders, prioritizing smaller accounts. The precise distribution mechanism and rates are still unreported at the time of writing. However, with LFG holding just $87 million in assets and 11 billion UST in circulation, it seems doubtful that users will be made entirely whole.
The fallout of the LUNA meltdown
The timing of the LUNA meltdown was particularly unfortunate. Following the pandemic years, the macro environment changed for crypto with the war in Ukraine, spiraling inflation, and a hawkish Federal Reserve dampening appetites for risk. Traders and investors moving into safer assets took their toll on crypto prices.
With its almost 20% yield on what was then the third-largest stablecoin by market cap, the Terra ecosystem appeared to offer refuge. Investors were lured in, many of which likely lacked the understanding of the protocol to assess its risk profile accurately.
The 2021 bull run attracted newcomers to the industry who may not have even understood the difference between an algorithmic stablecoin and a fiat-collateralized stablecoin — or that the former has, more often than not, plunged into obscurity following a death spiral event.
In his investor note, Freeman writes:
“It is essential that we do not allow Algorithmic stablecoins to be used as a savings and spending tool by the broad population. It’s not practically feasible for every individual to become an expert on monetary dynamics before they decide which financial products to rely on.”
Stories abound of traders taking their own lives as their life savings evaporated before their very eyes, serving as a tragic reminder of the dangers of overinvesting. The fallout has impacted LUNA holders, many of whom could not sell their positions during the plunge from north of $100 to less than $0.01 because of Terra’s 24-day unstaking lockup requirement.
LUNA continued to hyperinflate before the network was halted as UST holders ditched their positions. Similarly, those earning passive income via Anchor may have exited positions way below the intended $1 peg. Undoubtedly, many of those burned will be put off cryptocurrency for a long time, and headlines gracing mainstream media publications cast the industry in a damning light.
It’s not just retail fleeing to safety at the onset of a bear market that has taken a hit. Several crypto-focused investment funds are rumored to have had significant capital tied up in the Terra ecosystem. Exactly which funds were impacted is unclear for now. Yet, while some smaller funds tweeted their lack of involvement, big players like Galaxy Digital, Jump Crypto and Pantera Capital have yet to comment publicly.
The more early-stage investment firms hurt by the LUNA implosion, the less likely we are to see a return to bullishness any time soon, particularly for smaller, more speculative crypto assets. Tens of billions of dollars evaporating in a matter of days — and its knock-on effect on the wider crypto market — will take time to heal.
Worryingly, other blockchains also support algorithmic stablecoins with similar mint-and-burn native token dynamics. Much smaller than Terra, the impact of TRON’s USDD imploding, for example, would be limited.
Yet, the recent drama hasn’t damped TRON founder Justin Sun’s enthusiasm for algo-stablecoins. On May 12, he announced an even more unsustainable-sounding 40% yield on the TRON-based JustLend platform, raising eyebrows across the industry.
The regulators are watching
Hammering yet another nail in the return-of-the-bull-market’s coffin is the regulatory attention the Terra drama has brought. United States Treasury Secretary Janet Yellen immediately spoke out about the situation. Renewing her calls for strict stablecoin regulation, she told the House Financial Services Committee on May 12:
“I wouldn’t characterize it at this scale as a real threat to financial stability, but they’re growing very rapidly and they present the same kind of risks that we have known for centuries in connection with bank runs.”
Preceding the LUNA incident by a matter of days, the Federal Reserve published its May 2022 Financial Stability Report. Stablecoins are highlighted in it as a growing concern for the central bank.
Earlier this year, the Biden administration signed the first-ever U.S executive order addressing cryptocurrency, in which stablecoins were featured. The document did not make any sweeping policies, favoring a research-led approach. With government agencies eyeing the crypto industry, and particularly stablecoins, closer than ever before, as well as countless retail investors burned by LUNA, it’s easy to foresee a harsh crackdown on algorithmic stablecoins and much greater oversight for centralized stablecoin issuers.
There is concern within the industry that LUNA may have destroyed whatever leniency-for-the sake-of-innovation regulators were willing to cede. This could have a permanent damning impact on the DeFi sector, to which stablecoins are currently integral.
Indeed, the LUNA meltdown has brought about some of crypto’s darkest days. While the digital asset industry will almost certainly survive, the actual scope of the event’s impact will reveal itself over the coming weeks and months. Crypto’s not over, but many of its biggest supporters are hurting badly right now — and criticism is more justified than ever.
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