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Earlier this month, TerraUSD, a type of cryptocurrency known as a “stablecoin”, crashed. This isn’t “supposed” to happen – stablecoins are intended to be pegged 1-1 to a fiat currency, typically to the US Dollar. The currency, also known as UST, fell from its intended value of $1 to below 40 cents, at one point hitting a low of $0.31. The crash of what was at the time the third largest stablecoin sent shockwaves throughout the broader cryptoasset space, which are still being felt. In the immediate term it has resulted in collapse in value of the associated cryptocurrency called Terra (also known as LUNA), whose value has fallen over 99%. The dramatic fall was likely felt most by holders of UST, as users typically hold the majority of their funds in “safe” stablecoins to dampen volatility associated with other assets.
As with some of our previous posts, before we discuss what happened, and what some of the possible implications are, it’s worth taking a digression to give some background information.
The what and why of stablecoins
One of the common criticisms about popular cryptocurrencies such as Bitcoin and Ethereum is that their values are perceived as being highly volatile. Whilst it’s common for any traditional fiat currency’s value to fluctuate over time, these usually occur over long periods of time and within relatively modest ranges. As most consumers are paid, and pay, with the same currency, the immediate impact of currency fluctuations are usually not immediately obvious. However, a sudden drop in the price of a cryptocurrency, such as the massive drop in the price of Bitcoin following the Mt Gox hack, leaves the holders of that currency with an immediate loss in purchasing power. This history of volatility reduces the appeal for cryptocurrencies as a payment mechanism. Indeed, the narrative about Bitcoin in particular has shifted from a means of payment to be a store of value.
Stablecoins were introduced as a means of addressing this perceived weakness. Stablecoins are cryptocurrencies whose value is typically pegged to that of another currency (most commonly US Dollars), but they can also be pegged to the price of another commodity, such as gold. The means by which a stablecoin maintains its value can vary, with three mechanisms in particular being explored in the market today.
The most easily understood are fiat-collateralised stablecoins, where a reserve of a fiat currency is maintained as collateral assuring the coin’s value. This means that, in theory, a $1 stablecoin is backed up by $1 held in reserve. The most well-known of these is Tether (also known as USDT), but also includes others such as USD Coin (USDC). As the reserves are held off-chain (e.g. as traditional dollars or cash-equivalents deposited at a bank), the ability to verify the reserves depends on the transparency of the issuer. Some issuers release third-party audit reports to publicly evidence their collateral, but this approach is by no means standard, or even required in many cases due to the jurisdiction in which they operate. This itself has created some controversy, with Tether coming under scrutiny in the past.
Similar to these are crypto-collateralized stablecoins, where the collateral is another cryptocurrency. Given that the value of the collateral can itself vary quite significantly, the stablecoin is typically overcollateralized to provide a buffer, should the value of the collateral fall materially. For example, DAI, although pegged to the US dollar, is backed by Ethereum at a ratio of 150%, meaning you’d need to deposit Ethereum valued at $1.50 to receive a $1 DAI coin.
Finally, we have algorithmic stablecoins. These use algorithms and smart contracts to manage the supply of tokens in circulation in order to maintain price stability, such as reducing (or “burning”) the number of tokens in supply when the price falls, or issuing more tokens when the price rises. TerraUSD, for instance, is an algorithmic stablecoin, and so far these are relatively unproven compared to the collateralized counterparts. Some question whether they are possible at all at significant scale.
Stablecoins have, consequently, become an important feature of the cryptocurrency ecosystem, with USDT and USDC, the two largest stablecoins, having more than $130bn in circulation.
What happened to TerraUSD?
The way TerraUSD (UST) is designed to function was through an association with the LUNA cryptocurrency, and a mechanism that means that it is always possible to trade $1 worth of LUNA for 1 UST. Stability is maintained through the use of an arbitrage mechanism.
How this functions, is that, if the price of UST is too high, the protocol incentivizes users to exchange LUNA for UST, increasing supply and lowering the price of UST. For example, if UST is currently trading above its target peg at $1.01, a user could trade $1 of LUNA for 1 UST, sell the UST, and make $0.01 of profit. As the trade of LUNA for UST increases the supply of UST, this should drive the price down. The process then functions in reverse if UST is trading below the $1 peg.
However, the events of the past week appear to have stressed this self-correcting mechanism beyond the point at which it can function. When UST fell below the $1 peg, the swapping of UST for LUNA wasn’t able to pull it back up, consequently causing LUNA itself to crash. Although it’s not yet clear exactly what caused UST to fall below the $1 peg in the first instance, there are a few factors that may have contributed to this.
One factor is the small matter of a lending protocol called the Anchor Lending Protocol. This is a lending protocol that allowed lenders to earn interest on their UST by matching them with borrowers looking to borrow UST, offering yields of up to 20% to depositors. This protocol ended up being home to $14bn of the total supply of $18bn UST, suggesting that the main demand for UST was for earning interest via Anchor, with some concerns that the 20% yield was unsustainable. At the start of the week, investors started to withdraw money from the protocol, potentially sending a signal that there was a loss in confidence in UST. If 20% yield sounds too good to be true, that’s because it is. Yields from Anchor were effectively being subsidized by VCs and Terraform Labs investors incentivizing use of the Luna ecosystem.
Terraform Labs, the company behind the Terra protocol, also announced in March that they were aiming to build up a reserve of Bitcoin to buttress the value of UST. Speculators may have interpreted this as a lack of confidence in the algorithmic self-correction mechanism, and in UST in general. LFG – the Luna Foundation Guard – was a vehicle set up specifically to help defend the peg.
There is also some speculation that there was a coordinated attack to destabilise UST, to allow the attacker to make gains based on resultant currency fluctuations. On 8th May, a single wallet sold $285m of UST via the Curve and Binance blockchains. If that user had also taken out a short position on LUNA, as some observers were speculating, they would benefit from the resultant drop in price in LUNA as the correction mechanism (reducing the supply of UST and increasing the supply of LUNA) took place. Additional analysis, however, has shown that instead of a single attacker, it’s likely that “the de-peg of UST could instead have resulted from the investment decisions of several well-funded entities” – effectively, sophisticated players in the market pulling out liquidity out of risk management instead of malice. This act, however, seems to have triggered the “death spiral” that took the protocol down.
The fallout
Terraform Labs is taking steps to attempt to shore up UST, including building up a deeper reserve, and endorsing a community proposal to reduce the supply of UST. Regardless of whether UST is able to recover its $1 value, the consequence so far is that many crypto investors will have effectively lost virtually all of the investments they had in LUNA, resulting in the familiar tales of those whose lives will be changed by this loss. Drops in value of other cryptoassets across the board have also taken place, with Bitcoin falling below $29k for the first time since December 2020.
As if the collapse wasn’t enough, Terraform Labs is launching “Terra 2.0” in an effort to reboot the platform. They plan to “airdrop” users a commensurate amount of new LUNA tokens to compensate for what they have lost in the collapse. Only time will tell to see how successful this launch will be or if the spectacular collapse of Luna 1.0 will be too much to overcome.
Interestingly, we also saw Tether deviate from its $1 peg a few days later. As the largest stablecoin by far, this is of keen interest to cryptoasset holders everywhere, as a similar collapse could have massive ramifications for the ecosystem as a whole.
The fallout for stablecoins in general is likely to be a further push for regulation. US Treasury Secretary Janet Yellen directly cited the run on TerraUSD in a hearing with the Senate Banking Committee. The UK Treasury has also announced an intention to bring stablecoins within regulation.
What this regulation ends up looking like is ultimately up to the regulators to decide, but we’re likely to see stricter guidelines on how issuers of stablecoins evidence their collateral. At present, this is largely voluntary, with no specific guidelines on what issuers produce, so this seems like a natural first step. However, as we’ve discussed previously, regulating an asset with a global reach brings with it its own challenges.
It’s difficult to picture an immediate future without stablecoins, as, when implemented well, they provide an important degree of stability to an ecosystem often characterized as being volatile and unpredictable. However, much like the fiat currencies they aim to emulate, user confidence will be crucial.
Note: This article is not intended to constitute financial advice, nor does any information in this article amount to a full or complete statement of the matters discussed or the investment risks relating thereto.
