Major Stablecoin Debacle. Part 1

    22 May 2022

    This past week will surely go down in the history of cryptocurrencies as the point that marked a major shift in attitudes towards stablecoins. On the one hand, it became clear that algorithmic stablecoins did not live up to expectations. On the other, authorities all across the world got a reason to regulate this segment of crypto business into oblivion.

    Last week’s collapse of the algorithmic stablecoin UST severely rattled the cryptocurrency market. This, despite attempts to return the coin’s dollar peg by issuing about 5 million LUNA tokens an hour to redeem and then burn UST.

    You may remember that the Terra ecosystem faced an attack when an unknown trader decided to suddenly sell 285 million UST. At the time, market participants classified the event as a FUD. Created by Singapore-based Terraform Labs in 2018, the UST stablecoin is part of the Terra blockchain project. Similar to such stablecoins as Tether and USDC, it is pegged to the value of the dollar. Though, unlike them, Terra does not have cash and other assets held in reserve to support the token. Instead, it uses complex algorithms and the sister token LUNA to stabilize the price.

    On May 8, UST lost its dollar peg amid an outflow of assets from the Anchor protocol following a reduction in the rate of return on deposits to 17.87%. On May 10, UST dropped in value again, as quotes fell below $0.62. The trend continued into Wednesday, May 11, when the stablecoin lost parity with the US dollar once more. In addition, LUNA – the digital currency used to issue UST – collapsed by 76.4%. As a result of this catastrophic inflation, Terra validators decided to stop the blockchain to prevent further attacks.

    The whole story, intense and eventful as it is, would be hard to do justice here. So let’s focus on the most crucial points.

    The primary one being the fact that the collapse of one of the most notable algorithmic stablecoins launched a chain of negative processes that all but disintegrated the once bright prospects of Terra (LUNA). By May 12, its capitalization had fallen to $230 million (-99.9% in just a week). It got to the point that crypto exchanges asked traders to refrain from UST operations. For example, the Upbit exchange explained that users should exercise maximum caution due to the abnormal volatility of UST and the associated LUNA token. The management of the Bithumb and Coinone exchanges banned deposits in LUNA outright and stated that the decision to resume operations would be made after the situation stabilized.

    It is all the more troubling considering that before the events of the past week, Terra (LUNA) was one of the ten largest cryptocurrencies by market capitalization. And its asset – UST – was the third largest stablecoin after Tether (USDT) and USD Coin (USDC).

    The attack on the algorithmic stablecoin itself was fascinating to watch. Here’s a brief recap:

    1. The OTC market attacker accumulated 1 billion UST and borrowed $3 billion worth of BTC.
    2. They then launched the FUD over the UST peg and sold all their BTC in an attempt to sow panic.
    3. Companies partially withdrew liquidity from Curve, after which the attacker took all the liquidity from the Curve pool ($350 million) and started selling UST on Binance, causing a small decoupling from $1.
    4. The Terra module has a daily limit of $150 million to restore the dollar peg, which would have been enough if the liquidity in Curve was $4 billion instead of $350 million.
    5. The company started to sell BTC, while the attacker increased the panic by continuing to drain UST and shorting BTC at the same time.
    6. What followed was the Terra network overload, stop of withdrawal from exchanges and the flight to Anchor.

    Shortly thereafter (many UST holders were still recovering from the initial shock), the head of Terraform Labs, Do Kwon, laid out a strategy to overcome the UST/LUNA crisis. It is pretty complicated, but the main thing is that the validators must backup the blockchain up to 1 billion LUNA and distribute:

    – 400 million (40%) to LUNA holders before the UST depeg. That would roll the network back to its May 8 state. The new network is supposed to be community-owned.

    – 400 million (40%) to be proportionally transferred to UST holders during the new network upgrade.

    – 100 million (10%) to Luna holders at the last moment of the network shutdown: last-minute LUNA buyers should be compensated for their role in trying to ensure the network stability.

    – 100 million (10%) to the community pool to finance future development.

    We will see how it goes. I think there are still serious discussions to be had both within the LUNA community and among investors in general. Meanwhile, according to South Korean media reports, Do Kwon’s wife turned to the local police for emergency protection due to threats from bankrupt investors.

    Another important point, which I simply could not leave out, is that other stablecoins, chief among them USDT, almost fell victim to the UST crisis themselves. Amid the chaos, USDT somewhat sank against the dollar, causing many of its holders to withdraw all their funds into fiat. They must have recalled the passions that boiled over a year ago around the question of to what extent and with what assets Tether backs its stablecoin.

    A widespread crisis of confidence in stablecoins seemed inevitable, but then USDT began to gradually rebound. It is not hard to see how: USDT has different mechanics and types of collateral, so one couldn’t dump its rate like with UST. There have even been examples of USDT losing its peg to the dollar by 2-10% – usually during a similar market panic – but the stablecoin proved its resilience every time. And if we were to delve deep into Tether’s history, we would find that USDT at times fell as low as $0.57 and rose as high as $1.32.

    Now, to counteract fears that Tether will lose its peg to the dollar, the company’s technical director decided to reassure investors. Most of the stablecoin collateral today is in US Treasuries, he said. He also emphasized that Tether remained stable even after repaying obligations to the tune of $600 million a day.

    I would even venture to suggest that the company unwittingly benefited from the crisis around UST, as it proved the reliability of Tether’s stablecoin. Looking at the situation from a distance, it’s clear that for many users around the world, USDT has become a real alternative to the paper dollar. Yes, the stablecoin inherited all its shortcomings and even more. But one crucial advantage remains: USDT is much less subject to external supervision and does not require a direct bridge with the banking system. You can easily exchange any cryptocurrency for it without worrying about price fluctuations. This feature is invaluable for traders, no matter how much of a sin it may be in the eyes of adherents of classical cryptocurrencies.

    Not that long ago, people clashed in discussions about Tether not being backed by “real dollars” – although the crypto community generally believes that the dollar itself is not backed by anything either and that the Fed prints as much of it as it wants. Nevertheless, ordinary users still have faith in the US currency.

    In fact, not only Tether, but also USD Coin (USDC), Binance USD (BUSD), and True USD (TUSD), all representing alternative finance on the blockchain, are as reliable as the fiat dollar. Real crypto fans, of course, would only cringe at the words “as reliable as the dollar”.

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