The Stablecoin Mania - Fall of UST and LUNA
A stablecoin that's supposed to maintain a price peg to the US dollar 1:1 crashed to $0.1 i.e $100,000 (60 million naira) becomes $10,000 (6 million naira). Loss = $90,000 (54 million naira).
A stablecoin that's supposed to maintain a price peg to the US dollar 1:1 crashed to $0.1 i.e $100,000 (60 million naira) becomes $10,000 (6 million naira). Loss = $90,000 (54 million naira).
But before we explore the main headline proper, I'll be explaining the concept of stablecoins to enable non-crypto native folks to get a hang of the discussion.
Let's get to it
What are Stablecoins?
Stablecoins are cryptocurrencies that are designed to maintain a price peg with other assets. It's like saying we can have a cryptocurrency that always mimics the price of gold or dollar.
Using the dollar, let's call this cryptocurrency USDT. For USDT to be considered a stablecoin based on the dollar, 1USDT must = $1.
Note: Stablecoins are not issued by the government of any country. For example, the US has no affiliation with USDT, USDC, DAI or any dollar-backed stablecoin you see out there in the market.
Why do we need stablecoins?
The cryptomarket is often subject to high volatility as most assets in it are still largely driven by speculation.
Stablecoins offer a way to escape the volatility of crypto assets without leaving the crypto market i.e moving your money to banks or cash.
For example, the current crypto market dump can be quite catastrophic for short-term investors if there's no way for them to easily move their money from volatile crypto assets like bitcoin into other stable ones in the market.
Additionally, it helps people escape the high inflation rate in their country,
Acts as a store of value (saving).
Acts as a stable medium of exchange.
You can easily conduct cross-border transactions for negligible fees in a very short time frame (less than a minute most times) without going through the costly and time-consuming traditional bank process.
Etcetera.
However, the irony is that a particular stablecoin that's supposed to serve this purpose is depleting so fast.
Imagine saving #10,000 in your bank last week and when you check your account this week your money has become #600.
Well, we'll get to it later.
So now, how does a stablecoin maintain its peg to other assets?
How can something that's not the US dollar or real gold always have the same value as USD or gold?
This is where we'll discuss 👇🏿
Types of Stablecoins
1. Collaterised Stablecoins
a. Fiat collateralised
b. Crypto collateralised
c. Commodity collateralised
2. Algorithmic backed Stablecoins
Fiat collateralised stablecoins -
Fiat collateralised stablecoins are created by holding the US dollar or equivalent credit notes in reserve.
It's like saying - for every dollar I lock up in a bank reserve, I receive a receipt that allows me to mint (print) an equivalent amount on a blockchain network.
I can then decide to sell/share some of the units of dollar this receipt allows me to mint (print) on blockchain networks with as many persons as I want.
Now, if I sold you some of these units, you can decide to redeem them for physical cash if you want or sell them to other people.
This is basically how top US dollar stablecoins like Tether (USDT), USD Coin (USDC) and BUSD are created.
Commodity collateralised stablecoins -
Commodity collateralised stablecoins work the same way as that of fiat which we just discussed.
However, instead of fiat currencies like the US dollar, euro, naira, etc. you are using commodities like gold, silver, oil real estate, etc.
Examples are PAXG and Tether Gold which maintain a price peg with gold. So instead of buying physical gold for investment purposes, you can just buy PAXG stablecoin.
Crypto collateralised stablecoins -
Note: I wouldn't go much in detail for the sake of those who are still new to cryptocurrencies.
Crypto collateralised stablecoins are created via holding other cryptocurrencies as collateral. Because the high volatility of cryptocurrencies makes it impossible for their price to be stable, this type of stablecoins is over-collateralised.
Say, instead of holding $10,000 worth of bitcoin in reserve and minting $10,000 worth of a stablecoin, you hold $30,000 instead.
This is to ensure the currency maintains its peg to the dollar so that even if the price of bitcoin falls, the large amount of BTC in the reserve will cover for it.
However, several issues plague these types of stablecoins mentioned above -
Fiat and commodity collaterised stablecoins rely on a central entity which is directly the opposite of what cryptocurrencies are supposed to represent.
Additionally, accusations have been levied against some of them concerning their reserves.
While crypto collaterised stablecoins are decentralized, they are capital inefficient because of their reliance on being over-collaterised.
Hence, the need for a solution that satisfies the condition of decentralization and capital efficiency at the same time.
Algorithmic backed stablecoins -
Algorithmic backed stablecoins aim to use algorithms to maintain a price peg to other assets.
For example, I use computer algorithms to ensure that if I mint a coin (say UST) it always stays $1 regardless of the price of other cryptocurrencies.
The difference between algorithmic stablecoins and the other ones we discussed earlier is that there are no other asset like fiat currencies (US dollar, euro, naira, etc.), cryptocurrencies (bitcoin, ether, ADA, etc) or commodities (gold, oil, real estate, etc.) backing them.
A lot of projects have aimed to build algorithmic stablecoins in the past, but they all failed until the emergence of UST - the brainchild of Terra (LUNA).
UST - Destined For The Top... Or Not
Before you go on...
Many of my arguments here are based on facts, personal insights, opinions, and views from other experts.
I ignored some DeFi activities that happened behind the scene for the sake of length and easy understanding.
How does UST work and maintains its dollar price peg?
Terra's algorithm allows users to mint UST by burning LUNA tokens.
Crypto burning in layman's terms simply means taking coins out of existence permanently, hence reducing its supply.
That's by burning one dollar worth of LUNA tokens, you get 1 UST in return i.e if 1 LUNA is $100, by burning 0.01 units of LUNA you get 1 UST.
But here's the catch…
You can also mint new LUNA tokens by burning UST i.e you'll always get 1 dollar worth of LUNA tokens by burning UST even though UST loses its price peg to the dollar.
If the value of 1 UST falls to $0.8, you can still use that 1 UST to mint $1 worth of LUNA tokens regardless.
The logic applied by the Terra team here to maintain the peg of UST is the basic law of demand and supply in economics
If the price of UST is trading above the dollar peg, say 1UST = $1.1, arbitrage traders are incentivised to use their LUNA tokens to mint new UST and swap for other tokens.
As new UST is minted, its supply increases, hence, pushing its price back to $1 = 1UST
On the other hand, if the price of UST falls below one dollar, say 1UST = $0.99, arbitrage traders capitalize by buying a large amount of UST tokens and selling it (burning) for LUNA at a rate of 1UST for 1 dollar worth of LUNA.
Hence, they make a profit of $0.01 for each UST sold. This act reduces the quantity of UST in circulation, hence, pushing its price back to 1UST = $1.
When supply increases in correspondence to demand, price goes down. And when supply reduces in correspondence to demand, price goes up.
But why will people want to hold UST when there are other top stablecoins in the market like USDT, USDC, BUSD, DAI, etc.
This is where the Anchor Protocol comes in
The creators of Terra promised an 18-20% APR (interest) to people who stake their UST on Anchor Protocol (staking is kinda similar to depositing your tokens in a bank for interest).
Hence, encouraging more persons to purchase LUNA and burn them for UST.
The two-way benefit here is this:
The more LUNA tokens are being burnt out of existence, the more LUNA tokens become deflationary (they simply become more valuable due to less supply)
The ability to create more UST tokens increases as LUNA gains more value, making UST a very large market.
Well, all was going as planned as Terra overtook Binance Smart Chain to become the second-largest blockchain network in terms of Total Value Locked with over $14 billion staked in Anchor Protocol.
UST and LUNA broke into the top 12 cryptocurrencies by market capitalization,
LUNA even hit an all-time high of $119
until...
The Fall of UST and LUNA
Speculations are that it was an attack.
How it started
In March, the Luna Foundation Guard purchased about $1.5 billion in bitcoin to act as support for UST.
The plan - If UST falls below its $1 peg, sell some of the bitcoin in the reserve to purchase UST until it reaches its peg back.
Why not combine with other stablecoins instead?
Maybe because of pride after all the boasting of Do Kwon and LUNAtics (LUNA community) or because they will loose their market flare. Who knows?
Speculations
The attackers borrowed or shorted about 100,000BTC (which means they must be very rich or have access to enough liquidity to pull this one)
Maybe they did short other coins too but BTC makes more sense for the attack because of its high liquidity.
Then they bought over $1 billion UST OTC (over the counter) i.e not in an exchange.
The attack begins
A lot took place in the 3pool and 4pool liquidity pools in Curve Finance that I don't wanna explore because of the non-crypto native folks.
So let's just move on to here…
About $2 billion UST was removed from Anchor Protocol at once and sold in the market (probably some of the UST purchased by the attackers). Hence, sending the price of UST below one dollar.
LFG (Luna Foundation Guard) starts buying UST by selling their BTC reserves to restore the price peg to $1. This saw the price of bitcoin plummeting because of the selling pressure (basic demand and supply).
The attackers started dumping more UST which pushed its price down further.
And the more LFG sold their BTC reserves to restore the peg, causing a bearish pressure on the price of BTC (exactly what the attackers wanted since they already shorted/borrowed BTC and maybe other coins).
Note: BTC dominates over 40% of the entire crypto market capitalization and has a high correlation with all crypto assets. Thus a heavy price decline in BTC will generally affect the entire crypto market.
Counterintuitive approach from the LFG right?
Arbitrage traders tried to leverage the situation by trading (burning) their depegged UST (probably $0.89 at this point) for $1 worth of LUNA.
In theory, this should help LUNA retain its price peg.
Go back to where we explained how UST works to understand better.
However, Terra had a speed limit - only $100 million worth of UST can be burned for LUNA each day.
FUD (Fear, Uncertainty and Doubt) became widespread in the market as investors started removing their UST from Anchor Protocol to sell for whatever amount they can get on centralized exchanges. This made the price of UST de-peg even more.
Fear of the UST/LUNA mechanism sent the price of LUNA tanking too.
Trading (burning) UST for LUNA means more LUNA in circulation = lower price.
Again, basic demand and supply.
Between, traders started shorting LUNA and UST (possible on FTX) which further depleted its price.
The supply of LUNA rose from about 340 million to 6.5 trillion within a few days as its price went below $0.00001 from an all-time high of $119 (basic demand and supply again).
UST, on the other hand, went as low as $0.05.
Centralized exchanges decided to ban the withdrawal of UST.
By this time people have lost billions of dollars from holding both UST and LUNA. Some lost all their investments. While others, their life savings.
UST and LUNA lost about $60 billion from their combined market cap.
Oh, how has the mighty fallen?
The crypto market wasn't left out as over $400 billion was wiped out from its entire crypto market. Never has this happened before. But we move.
4 Important Lessons From The Fall of UST/LUNA
1. While the attacker may have made good money from the attack, I think this is not only about money. There may be other added factors - politics, pride, hate... who knows?
2. It will be improper to think that all types of stablecoins are dangerous because of the crash of UST.
There might be some scepticism with USDT, but some stablecoins are honest with their dealings.
3. In the web3 space, we have innovative and experienced developers, marketers, product designers, etc.
But only a few persons with sound experience in economics and finance
4. If you're a trader, then you should consider adding to your armoury of fundamental analysis - basic economics, financial models, statistics and mathematics.
What are some of the lessons you learnt from the fall of UST?
Share with me on the comment section.
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