The not-so-stable stablecoin: The crash of the Terra-UST stablecoin

WHAT HAPPENED?

On 8 MAY 2022, the TerraUSD (UST) cryptocurrency, which was supposed to be pegged to the USD, began to fall quickly from parity to less than US $0.10 in just over the span of one week. From 8 MAY to 14 MAY, UST's market cap has also fallen from $18B to about $2B. Since then, the UST has been officially de-pegged from the USD, and the market cap has settled near $600M. In addition, LUNA, which TerraUSD use as a counterweight to maintain TerraUSD's peg to the USD, quickly started its descent which saw its price fall from ~US $85 on 5 MAY to just about $0.01 in less than one week. As of 20 MAY, LUNA's market cap fell from US $28B on 5 MAY to about US $1B.

WHY DOES IT MATTER?

• Financial losses: This event has, no doubt, ruined many people's lives and undoubtedly hurt the entire crypto market. At least $15B of crypto value has been wiped out because of this event. And this was just the direct impact of the UST/LUNA cryptocurrencies. Indirectly, Bitcoin's price has also fallen from about US $40,000 to about US $26,000 before stabilising at nearly US $30,000.
• Decrease in TRUST and momentum: Investor loyalty and popularity are the key drivers for the continued cryptocurrency market. In addition, for a specific cryptocurrency, a sound narrative and the investor/consumer's trust in its decentralised system (and its products/services) are the key supporting factors for the cryptocurrency's continued growth and its aggregate return. This event will undoubtedly shake investors' and consumers' confidence as well as their appetite for the category and the fundamental desire to ripe the benefits of a decentralised system and the need for centralised policing and protectors of its system users into direct conflict.
• Expect increased regulations: The IMF, US Congress, MAS, and many other government entities discussed increased regulation in the crypto market before this incident - because stablecoins present adaptation risks for CBDCs (Central Bank Digital Currencies). As a result of this incident, there are signs that the pace of regulatory discussions has been sped up due to this incident. In fact, as of this writing, two US senators (Cynthia Lummis of Wyoming and Kirsten Gillibrand of New Year) introduced the "Responsible Financial Innovation Act" targeting directly at the crypto-market and the stablecoins.

THE DETAILS

So what happened? How can one of the major cryptocurrencies crash so quickly? And, how can a stablecoin, which was supposedly pegged to the USD and provide a stable store of value, fall drastically?

To fully understand and appreciate the Terra UST event, there are several concepts that we must introduce:

• What are cryptocurrencies?
• What are stablecoins, and how do they work?
• What are De-Fi and the Anchor Protocol?
• What is Terra and What happened?

What are cryptocurrencies?

Cryptocurrencies

Many of us have heard about cryptocurrencies, and more specifically, Bitcoin. These cryptocurrencies are designed to work as a medium of exchange digitally without relying on the use of any centralised authority such as the government or bank to uphold or maintain it.

Bitcoin and other cryptocurrencies are extremely volatile, especially when compared with conventional financial instruments like stocks and bonds. That volatility is one of the key crypto's appeals for investors to a certain extent. An investor can, of course, lose all of their money overnight on any coin or token, but it is also not out of the realm of possibilities that one could also become a millionaire overnight. 

To illustrate, the chart below shows the Bitcoin prices since Jan 2021. The price of bitcoin has swung from US 30,000 to a high of almost US 60,000, back to US 60,000 within the first eight months of 2021. And then again, within less than six months, it went up to almost US 70,000 by the end of 2021. As of 18 May 2022, the Bitcoin price is again settled at about US 30,000.  

In comparison, the S&P500 started 2021 at about 3,800 points, climbed to the high of nearly 4,800 points, and eventually settled at around 4,100 points as of 18 May 2022 – a range of about 1,000 points over the course of 17 months.

The same can be said for other major cryptocurrencies with a significant market cap, such as ETHER, XRP, etc.

What are Stablecoins?

For cryptocurrencies to be seriously considered a form of payment (and a store of value), it is important to address (or provide a shelter from) the volatility and risks of these cryptocurrencies – among other limitations. With that in mind, stablecoins have become more central to the crypto ecosystem over the past few years, serving important functions for investors and speculators.

A stablecoin is a form of cryptocurrency. However, instead of being "mined'' by an open, distributed network of computers performing a combination of complex math and recordkeeping, a stablecoin generally derives its price based on the value or is pegged to another underlying asset(s).

There are many stablecoins available today. Some of the most popular stablecoins are Tether (USDT), USD Coin (USDC), Dai (DAI) and Pax Dollar (USDP). For example, USDT is one of the most popular stablecoin, with a US $73B market cap, that crypto enthusiasts have used for years to leverage their cryptocurrency trades. In theory, the USDT is pegged to the U.S. dollar, and it should remain unaffected by market volatility such as those experienced by Bitcoin or Ether or XRP.

There are generally four types of stablecoins in today's cryptocurrency market.

Fiat-backed Stablecoins

When a user deposits US $1 (of fiat currency) into Tether's reserve by 'selling' fiat USD to 'buying' USDT, the tether system will issue a corresponding digital amount of tokens. The created USDT can then be sent, exchanged, or stored in a digital wallet. Conversely, if a user redeems his USDT to USD (or other fiat currency), the corresponding value in USDT will be destroyed.  This mechanism ensures that each USDT has a 1-to-1 dollar parity at all times.

In general, the 'asset-backed' nature of this cryptocurrency provides the necessary trust to the user that 1 USDT will be worth about US $1, whenever he/she buy/sell this token and thereby maintaining stability and parity with the US dollar. According to Tether's website in 2019, the site claimed: "the stablecoin (USDT) was backed by reserves in traditional currency and cash equivalents (and sometimes other assets from affiliated entities)." More recently, the Tether’s site has stated that “All Tether tokens are pegged at 1-to-1 with a matching fiat currency and are backed 100% by Tether’s reserves.”

Commodities-backed Stablecoins

The commodities-backed stablecoins work in the same way as fiat-back stablecoins. The value of commodities-backed stablecoins depends on the value of one or more commodities that it represents. These stablecoins can be redeemed for (and take possession of) the equivalent valued commodities or converted the equivalent valued commodities into stablecoins.

An example of a commodity-backed cryptocurrency is Digix Gold (DGX). It is an Ethereum-based token that is backed by physical gold, where 1 DGX represents 1 gram of gold. This gold is stored in a vault in Singapore and gets audited every 3 months.

Crypto-backed Stablecoins

Instead of being backed by physical assets, it is generally backed by an [basket] of cryptocurrency (or cryptocurrencies). This type of stablecoins is generally backed by the largest cryptocurrency by market caps, such as Bitcoin or Ethereum. This allows crypto-backed stablecoins to be more decentralised than their fiat counterparts. To reduce price volatility, crypto-back stablecoins are often over-collateralised so they can absorb price fluctuations of the collateralised assets.

For example, to get $100 worth of stablecoins, one would need to deposit $200 worth of Ethereum tokens (or Ether - ETH). In this case, it is 200% collateralized, even in the event of a 25% drop in price, the $100 worth of stablecoins are collateralized by $175 worth of ETH. Furthermore, to distribute the risks, this type of stablecoins are often also be backed by a basket of mid-to-large market cap cryptocurrencies.

Examples of this type of stablecoins include DAI and jFIATs.

Non-collateralised (or Algorithmic) Stablecoins

Unlike physical assets backed stablecoins such as physical fiat currency or other forms of physical assets, the non-collateralised stablecoins are not backed by any underlying assets. Instead, a non-collateralised stablecoin uses sophisticated algorithms to adjust the supply the stablecoin in order to establish its value at the desired level. This is a model known as 'seignorage shares'.

In general, the algorithm creates new stablecoins as demand increases to reduce the price back to normal. And conversely, if the price of the stablecoin is too low, the coins in the market are bought up to reduce the supply circulating. In theory, the prices of these stablecoins would remain stable as they are driven (and managed) by the overall supply and demand situation.

This is the most decentralised form of stablecoin, as it is not collateralised by any assets that could be controlled centrally.

The longest-running algorithmic stablecoin is Ampleforth (AMPL). Another well-known one is BAC, and of course, the Terra USD (or UST).

What is Decentralised Finance (DeFI)?

Before we dive into exactly what happened to UST and LUNA, we should also have a high-level overview of DeFI or Decentralised Finance.

DeFI is a form of financial technology (fintech) that is based on blockchain and cryptocurrency technologies. Unlike traditional financial systems, DeFI applications remove the controls that banks and government institutions have on money and financial products and services. Financial products and services essentially disempower middlemen and gatekeepers - and return the power (and profits) to everyday people via P2P exchanges.

Similar to traditional financial products and services, dApps and protocols are already being used for traditional financial transactions (such as payments, securities trading, insurance, lending and borrowing), decentralised exchanges enabling peer-to-peer financial transactions (such as Coinbase, Gemini, Binance), e-Wallets, stablecoins, NFTs, etc...

defiprime.com has a good ecosystem map of popular DeFi Products (image below)

The Anchor Protocol

The Anchor Protocol is an example of the DeFi App. It is, in fact, Terra's main DeFi product. According to its whitepaper, the Anchor Protocol is a decentralised "saving protocol created on the Terra blockchain that offers yield powered by block rewards", and it offers a "principal-protected stablecoin savings product that pays depositors a stable interest rate". This is very similar to our savings account at our neighbourhood banks. In effect, this DeFi App provides stablecoin owners with a way to earn interests just as we would by depositing cash in the savings accounts with our banks.

For example, Bob could deposit US $1,000 worth of Terra-USD (or UST) - a supposedly stablecoin - in the system. The Anchor Protocol would then turns around and lend BOb's deposits to another investor Mary. Similar to any real-world lending, Mary would also put down collateral against the borrowed amount. Mary would pay interests to the Anchor Protocol, and a portion of the paid interests would go back to Bob. Again, as with the real-world lending scenario, for Anchor Protocol to be sustainable, there has to be (I) enough borrowers, and (II) the borrower's interest rate should be at least the same or higher than the lender's interest rate.

The Terra USD (or UST) and how has it caused one of the largest market crashes in cryptocurrency's history in a matter of days

What are Terra UST and LUNA?

Like other non-collateralised (algorithmic) stablecoins, the UST leverages a complex set of algorithms that creates stability in the price of the UST by artificially managing the supply and demand of the UST and Terra's native token LUNA as its underlying asset for the UST, instead of the US fiat currency. If one UST is created, the equivalent valued LUNA token will be burnt from the ecosystem. Conversely, if one UST is destroyed, an equivalent valued LUNA token will be created by the algorithm.

So when the price of 1 UST exceeds that of US $1, someone will sell LUNA for the UST coin or dollars, and with the new UST coins coming into the market to inflate value and drive it back to a dollar. However, when UST’s value falls below a dollar, the token is sold for LUNA or dollars for profit. This algorithm essentially relies on investors' / trades' appetite to take advantage of the arbitrage opportunities of the pricing created as a result of the supply and demand situation of the Terra ecosystem.

So what went wrong?

Unfortunately, unlike the fiat or asset-backed stablecoins, the UST and LUNA were both speculative assets. It has been rumoured that, perhaps, a group (or some organisation) realised the scale (and the weakness) of the arbitrage opportunity system. In this potential scenario, a group borrowed a large amount of BTCs and used these BTCs to purchase a large amount of USTs. The group has dumped a large amount of USTs and BTCs into the market, driving down both the price of USTs and BTCs. While stablecoins could fluctuate, to a certain extent, at +/- 1% for a very short time, however, the massive dumping of USTs and BTCs triggered a cascading sales of both assets.

Did subsidised lending with Anchor add to the fire?

Without going into all the details on loan-to-value (LTV), staking, and other technical details, the Anchor Protocol offered holders an APY of 20% (compared to most banks who have been paying close to 0% APY). Essentially, Terra is subsidising Anchor's growth and adoption. The hope was that by 2024, the high APY would expire, but by then, there would be a vibrant ecosystem, with many using the Anchor protocol for their De-Fi needs. Because the APR is so high, there has consistently been a situation where "deposits have gone up a lot and borrowing down". To maintain this, the Luna Foundation Guard has intervened by injecting UST into the system on more than one occasion.

What added to the fuel was that up to 75% of the USTs (~US $14B) were in circulation at the beginning of May with the Anchor Protocol due to its high 20% APY. With such a high % of UST in circulation locked up in the AP, it is very clear that most owners of USTs are really in it for the high passive income/yield from the AP. As a result of this sudden massive market crash of the USTs and BTCs, it likely triggered more withdrawals from the Anchor Protocol platform could repay (i.e. bank run). According to estimates by Forbes, about US $5B might have withdrawn from the platform. This excessive amount of withdrawals and selling subsequently triggered the aggressive selling of LUNA. With both USTs and LUNAs crashing, it eventually completed the de-pegging of USTs against USD parity - which eventually de-pegged and crashed to close to US $0.

What are the implications of the UST/LUNA crash?

As a result of the crash, over $2 billion worth of crypto market cap has been wiped off the market. There are a number of more critical implications for the large crypto market:

1. Prior to this incident, there were a lot of discussions about the need to regulate the crypto market by many governments - or outright banning crypto. We should expect there will be more regulation in the crypto space. There could be regulations limiting only institutional investors while banning retail investors across all crypto and virtual assets or to the stablecoins - since they are a direct competitive threat to central bank digital currencies (CBDCs) and traditional fiat currencies. Most recently, Janet Yellen called for stable coin regulation by the end of 2022. More likely, regulators might decide to ban all algorithmic stablecoins altogether.
2. This recent crash of the crypto market has taken much of the capital and enthusiasm, and, most importantly, trust from the crypto market. This will, no doubt, dampen the growth of the crypto market and many of its dApp applications (i.e. DeFi) over the next couple of years. This will very likely impact the retail adoption and utilisation of cryptocurrencies. 
3. The market interest level could be tamed over the near term, and there could be limited price movement (at least upward). Many experts have openly suggested that the current cryptocurrency winter might last upward to about three years - assuming no additional events which may tame its recovery (i.e. another crash and/or regulations)