How Crypto’s Crash Broke The Buck For TerraUSD

Crypto critics who believe that the industry is nothing more than a series of intricate ponzi schemes are puffing their chests today.

TerraUSD (UST), a digital token with a $16 billion market capitalization that is designed to maintain a 1:1 peg with the dollar, known as a stablecoin, nosedived over the past 24 hours. Its price fell below $.65, before somewhat recovering to $0.93 as of this writing. In other words, UST failed spectacularly at the one thing that it was supposed to do – maintain parity with the dollar.

The episode is reminiscent of when the Reserve Primary Fund, a money market mutual fund with $68 billion in assets fell from $1 per share net asset value to $0.97 during the financial crisis after Lehman Brothers filed for bankruptcy in 2008. It owned Lehman commercial paper and the investment bank’s collapse caused a panic among money market fund holders who rushed to redeem shares. Money market funds were thought to be as safe as FDIC-insured savings accounts.

In terms of TerraUSD, the drop happened to fall on the same day that the Federal Reserve issued its biannual Financial Stability Report, in which stablecoins featured prominently. The report noted how stablecoins can be subject to runs on money market funds, especially during times of stress when the assets backing these tokens can become illiquid.

So what exactly happened with UST? To begin, it is important to note what makes the asset unique, or dangerous, within the world of stablecoins. UST is an algorithmic stablecoin, which means that it operates in a different way than most similar assets. More popular stablecoins, such as tether (USDT – $82 billion market cap) and USD Coin (USDC – $50 billion market cap), are backed by assets such as fiat dollars in a bank account, treasuries, or short-term commercial debt. This approach is also dangerous since issuers have at times been opaque about the exact breakdown of their reserves, USDT has been especially controversial, and watchers are concerned that these assets may not have enough liquid collateral to redeem the $100+ billion in assets that they support.

That said, those appear to be a paragon of stability when compared to UST. Instead of being backed 1:1 by tangible assets at a bank or custodian, UST uses a complicated setup with another token, LUNA, to try and maintain its peg. LUNA is a native token of the Luna blockchain, a decentralized platform like Ethereum that can run various types of applications like decentralized finance programs (trading and lending) and support non-fungible tokens (NFTs). Every UST is supposed to be redeemable for $1 worth of LUNA, currently priced at $30.00

Of course prices fluctuate just like in the fiat world. The exchange rate for a dollar against other currencies adjusts on a daily basis. In UST’s world, LUNA is supposed to be a stabilizing mechanism to help return the price of UST back to $1 when it deviates. If UST falls below $1, there would be an arbitrage opportunity to buy a UST for say $.98 and then trade it for $1 worth of LUNA. Eventually this trade should bring the price back into sync.

The system seems elegant on paper and a clever bit of financial engineering, but it is unproven. There have been multiple unsuccessful attempts in the past to create an algorithmic stablecoin. For instance, about a year ago a token backing up the stablecoin IRON, called TITAN, dropped to zero amidst market uncertainty in what the team called “the world’s first large-scale crypto bank run.”

It looks like Luna tried to learn from these failures, and concerns that some purchasers may worry about LUNA’s underlying value, so it also bought over $3 billion worth of Bitcoin and Avalanche as a further stabilizing mechanism for the protocol.

Last weekend, UST started to deviate from $1 as macro uncertainty continued to mount in the light of the 50bps rate increase on Wednesday, concern about April’s inflation numbers, released tomorrow, and the double-digit dips impact most crypto tokens in recent days. There were some allegations that an unknown actor was trying to flood the market with UST to attack the protocol, and one pseudonymous actor even took out a very public $10 million short position against the asset.

As all of this was happening, over $5 billion worth of UST was being drained out of the Anchor Protocol, a DeFi lending application that runs on Luna. This represents about a third of the entire market capitalization, which could be seen as a vote of no-confidence in the asset. This was bound to happen at some point anyway. Participants in this protocol had been receiving an unsustainable 20% yield on their hold, which is abnormally high, even for crypto. Eventually this was going to unwind.

As you can see above the ball of yarn started to unwind over the weekend, and even when the Luna team deployed all of the bitcoin at hits fingertips, as well as hundreds of millions of dollars in UST to market makers in an effort to bootstrap liquidity and brings things back to an equilibrium, it has not recovered. It may never, and even if it does the reputational damage will be almost impossible to overcome.

If that was not enough, the collateral damage was extensive. LUNA saw its market capitalization drop from over $30 billion to $10 billion in the past five days and its price is down 64% over this time frame. Additionally, because the team flooded the market with bitcoin in an effort to protect the price peg, it added further selling pressure to that asset, seeing it drop below $30,000 for the first time since last July. In total, crypto’s market cap has lost about $300 billion in the past few days.

If there is one saving grace here, it could be that the other major stablecoins such as USDT and USDC have largely managed to avoid damage themselves. However, as they continue to grow in size, it is fair to assume that regulatory scrutiny will only grow in light of these events.

It is also fair to wonder if or when there will ever be a successful algorithmic stablecoin. UST surged in no small part due to backlash among crypto natives to the centralized way in which USDT and USDC operate, which they see as anathema to crypto’s ideals. Of course, decentralization is a spectrum, so perhaps there is a middle ground between purely algorithmic tokens and the decentralized model. Regardless, no tokens will succeed until they can prove their viability during times of stress, something that the traditional financial sector also struggles with today.