Crypto
May 9, 2022
UST Stablecoin Depeg - Will It Recover?
DeFi Educator
In-House Research Analyst and Content Writer.
A $20 billion algorithmic stablecoin is losing its peg and a $30 billion Layer 1 protocol to back that stablecoin is on the brink of destruction.
No scam, hack or rug pull in recent years even comes close to the magnitude of this possible death spiral.
Even the Federal Reserve took notice:
So will UST unwind or will it recover?
If you are already familiar with the Terra ecosystem you can go ahead and skip the introduction and refresher on how UST maintains its peg.
UST is an algorithmic stablecoin.
It’s different from a normal stablecoin in that it isn’t backed by any type of collateral, such as other over-collateralized or fiat backed stablecoins (such as USDC, USDT).
Because of UST’s success the Luna Foundation recently announced they will buy $10 billion worth of Bitcoin with their excess capital.
This did not however change the fundamental mechanism on how UST maintains its peg.
Why create an algorithmic stablecoin instead of a fully backed stablecoin?
Historically UST has depegged for a short duration twice.
Once when the protocol was in its infancy and another time when it was under pressure during the BTC crash May last year.
So if they recovered in the past, why this fear?
For that we first must cover the basics.
Let’s look at two scenarios:
- Either UST is worth more than 1$
- or UST trades under 1$.
The circulating money supply CONTRACTS within the system.
When UST's price< 1$, anyone can give 1 UST to the system and they will get 1$ worth of $Luna in return.
So instead of selling your 1 UST(1$) for a loss in the open market (say 0.8$), you can just give it to the system for 1$ worth of $Luna and make a quick 20%.
The system burns the $UST obtained thus reducing the circulating supply, which increases the price of $UST.
The arbitrage opportunity incentivizes people because they can buy 0.8$ worth of $UST from the market and sell it for 1$ worth of $Luna.
Thus it's dependent on market participants to bring back the pag.
The circulating money supply is expanded within the system, which reduces the demand for the currency.
When demand for the currency falls, its price also falls relatively.
When $UST's price> 1$, anyone can give 1$ worth of $Luna to the system and the system gives them 1 UST.
Then they can go to the open market and sell that 1 UST (which is worth 1$) for a profit (say 1.1$).
This also incentivizes people to give 1$ worth of $Luna to the system and get 1 UST back to make a profit.
Thus it's dependent on market participants to bring back the pag.
The main problem with algorithmic stablecoins is their reflexivity by design.
LUNA absorbs the volatility of UST's market: as UST goes above peg LUNA is bought and burned pushing LUNA's price up.
And as UST goes below peg LUNA is minted and sold pushing its price down.
UST is not as decentralised as people think it is.
@Defi_made_here on twitter makes the case that if 74% of demand comes from Anchor Protocol because of it’s high stablecoin yield (~18% at the time of writing), it is inherently not decentralised.
Imagine a situation where Anchor Protocol is exploited and UST is sold on the market.
Recently Anchor protocol moved from a static to a dynamic yield.
So instead of 20% it is being lowered over time with a minimum of 15% APY and will be reached in 2 months.
Now we are adding the launch of $USN and $USDD to the mix with their respective ~20% and 30% APY.
This could pose a problem as people will leave the terra ecosystem and move their $UST from anchor over to these new stablecoins with higher yield.
As UST is not backed by any collateral (aside from the BTC reserves) this could initiate a death spiral:
If demand for UST falls at Anchor Protocol, demand for UST falls.
As people sell UST → UST goes below peg → LUNA is minted and sold → LUNA supply increases means Luna price goes down.
This process is what is known as a "bank run" or a "death spiral," and can be visualized below
There is not enough liquidity in the system to absorb all the UST.
So as an UST holder you have to understand the risk reward.
The Reward: 18% APY which is being lowered to 15% over time on @Anchor_Protocol.
The Risk: There is not enough liquidity in the system for everyone to exit at the same time.
Worst case scenario: Depeg and Death spiral
Some big traders have bet and bet big against the algorithmic stablecoin:
Also this research analyst foresaw this scenario coming as early as January:
As I'm writing this UST is depegging to $0.84 on Coinbase and 0.82$ on Binance.
Let's look at the reasons why UST will recover versus why this might signal the end for the Terra ecosystem.
In the above tweet a number of explainer threads are given with reasons for why a repeg will occur:
- UST MCAP > LUNA -- No death spiral happens.
- UST is backed by user activities on the terra blockchain and cashflow generated by such
- Understand that arbitrage and Peg regaining takes time
- Backed by VC’s that might jump in. The likes of 3AC, Jump, Defiance. Well known VCs in the space with very deep pockets.
- There are protocols like @teamkujira and @whitewhaleterra buffering Anchor Protocol liquidations and arbitraging the UST peg so there’s no liquidation cascade scenario.
- There is now a new mechanism added to the mix to defend the peg: BTC reserves
BTC reserves decrease the risk of a death spiral.
How?
Because of reduced LUNA minting pressure. Instead there is now the option to swap UST to BTC instead.
A new on-chain mechanism is added to the Terra blockchain, that ensures to exchange always 1 UST coin for 0.98 dollars of BTC
Now, market participants can buy Bitcoin at a discount from the reserve, if UST trades off-chain below 0.98 dollars!
However this On-chain bitcoin reserve mechanism wasn't live yet. So instead the LFG council deployed $1.5 billion as a 'loan' to a market maker so they could manually perform this function.
There was some speculation that the Luna Foundation bought Bitcoin at 40k+ and then sold at a loss at 34k to defend its peg.
However that is untrue. Stablekwon, co-founder of Terra blockchain, explains:
There is $16.2 billion of UST left.
Peg defense reserves: $3billion of which they deployed 1.5$ billion
$Luna marketcap: $13.4 billion
Yes, there is a real possibility that investors panic. And the exit door becomes smaller and smaller.
Ever heard the saying: “The market can stay irrational longer, than you can stay solvent.”
Even if investors don't panic. The bottom seller doesn't voluntarily sell, but gets a margin call.
Below is a case in point of an unfortunate trader getting liquidated for $225 million on a LUNA trade.
Looking at the open interest for LUNA perpetuals, there is about ~$600million in open interest right now. With funding being negative, meaning it pays to be long right now. That is about 4.6% of marketcap. For reference Bitcoin is ~1.7% open interest of marketcap.
An open interest of 4.6% is not that out of the ordinary for Crypto. But liquidation cascades are certainly on the cards.
Demand for UST is pushed by setting up a 20% subsidized, short-term interest rate. Previously around 70% of UST was locked in Anchor Protocol to take advantage of this yield.
If capital rotation happens out of $UST to $USN and $USDD because of better yields, UST could unwind via a bankrun.
25% of UST on Anchor (before the bankrun) was backed by BTC. Technically, it could do it through Luna, but in case of a run, it seems unlikely that investors would choose to move to Luna. The main driver of demand for Luna (and therefore UST stability) is future expected demand for UST. During the bankrun the sell & mint pressure on LUNA will prove to make Luna worthless.
The actual, real, long-term solution must be to grow the ecosystem. But in the short term it is unlikely that such an alternative is found.
Keep it simple.
For every 1 UST that needs to be redeemed there must be 1 USD (or any other non-Terra asset worth 1 USD) willing to either buy UST at a price of $1.00.
Or, due to Terra’s arbitrage mechanism, buy LUNA at whatever price.
If there are more UST looking to be redeemed than there is USD willing to enter the Terra ecosystem, UST can not maintain its peg.
Or as @jonwu_ put it:
"UST is 100 magic dollars backed by 20 bitcorns and 80 magic beans.
But some people don't think it's worth 100 real dollars, so Luna foundation is selling bitcorns to buy more magic dollars.
To convince people they're worth 100 real dollars, all so the magic bean holders don't get sad."
Reasoning from first principles, you will see the problem is undeniable and dependent on investor psychology.
If you're allocated to Terra ecosystem then this is a bet that:
- Terra's founders (& VCs backing them) will deliver and keep a good public image
- a possible macro relief rally of Bitcoin, or rather limited downside
- a hope that your average marketparticipant doesn't stampede towards the exit door
Personally, not financial advice, other than short term trades to take advantage of the volatility I don't like investing on hope and don't see an asymmetrical risk/reward scenario right now to allocate to the Terra ecosystem for the long term.
Even though VCs might bail out UST, and the peg of UST will restore, trust takes years to build and just moments to shatter.
On a more positive note, had this happened in Traditional Finance, there would have been talk of doom and gloom and bailouts galore. But the bankers' bonuses would still be paid. The crypto space is incredibly resilient because counterparty risk can be clearly defined. A 2008 'too big to fail' moment wouldn't happen.
Stay tuned.
Next we’ll dive into NEAR’s new stablecoin $USN and TRON’s new stablecoin $USDD.
And compare how safe or different their mechanism is from UST.
