Michaël van de Poppe - 10 May 2022
UST loses peg, LUNA plummets in price; what happened?
Over the weekend the whole crypto market experienced a major drawdown. Everything was deep in the red despite low volume. And on Monday the downtrend continued.
In these turbulent times, when the crypto markets are experiencing huge downwards volatility, investors and traders position themselves to stablecoins to protect themselves from losses. Stablecoins are tokens with a fixed value and are often pegged to the dollar. These tokens are a great tool within crypto as a stable and safe holding within one’s portfolio.
Over the weekend many of these stablecoins saw huge inflows of capital as investors and traders exited their volatile crypto holdings for stablecoins. One stablecoin, however, experienced opposite effects and people were actually selling it en masse. This caused the stablecoin to lose its fixed value of a dollar to the point that it even dropped below $0.70. That is a drop of 30% for a token that is supposed to hold its value at all times. The coin in question is Terra USD or UST. A token that enjoyed high praise for its decentralized character and the fact that users could earn 20% APY yield.
Over the past few days the stablecoin proved to be unstable and lost a sginficant amount of value as well as a huge amount of market share within the stablecoin industry. This blog will bring you up to speed on how UST functions and how it collapsed over the weekend.
How UST works
For context purposes it is important to understand how UST works, because it is essential for understanding the current situation with the stablecoin. Without going into too much detail the following image describes the fundamental mechanics of the token.
UST is algorithmically kept at value which means that instead of the token being collateralized by other crypto’s or real world dollars, the value is derived algorithmically by burning or minting LUNA. This mechanism relies solely on arbitrage and the interplay between supply and demand.
Whenever UST is trading above $1 it signals that there is more demand than supply, causing the token to be traded at a premium above the 1 dollar mark. This opens up an arbitrage opportunity for arbitrageurs to come in and burn $1 worth of LUNA to mint 1 UST. They can lock in profit by selling the UST for other assets on the open market, because UST is above $1. This mechanism allows UST to expand in UST and meet the increased demand.
On the other hand, if UST is trading below $1 it signals that there is more supply than demand for the stablecoin. In this case users can burn 1 UST to redeem $1 worth of LUNA and sell the LUNA on the open market for profit. This contracts the circulating supply of UST to meet the decreased demand of UST.
Current reach of UST
With these mechanics in mind, let’s reassess what occurred over the weekend. The whole crypto market took a huge hit and all tokens experienced double digit negative returns. There were already some concerns on UST breaking its dollar peg and the consequences it could have across crypto. A great example is this medium post by Wheatstones from 4 weeks ago. Within the post he analyzes Anchor’s current model and concludes that it is unsustainable in its current form.
Before the crash, the total supply of UST in ciruclation was around $18bln with over $10bln locked in Anchor. This is a valid reason for concern as the billions in Anchor are simply taking the yield and are not being used for payments, transactions, or any other productive activities. If UST were to lose its dollar peg and depositors were to exit their position then this would cause a bank run and more downside for UST. The supply has to be absorbed by someone and if UST does not hold its peg then it could be disastrous for the LUNA.
If UST were to lose the dollar peg, then the shockwaves would be felt across the entire crypto space. UST has made its way to major DeFi platforms and is used to denote trading pairs on some of the largest centralized exchanges. UST is also the most used stablecoin within the Cosmos ecosystem. It is safe to say that the stablecoin has its tentacles across the crypto space and that it is a concerning situation if the stablecoin fails to deliver, i.e. fails to hold its dollar peg.
The Bitcoin reserve fund
Terra Form Labs (TFL), the team behind the Terra chain and all related tokens, was very much aware of these concerns of the public and the unsustainable yield on Anchor. In order to strengthen the confidence and the dollar peg of UST, the Luna Foundation Guard (LFG) was founded, a non-profit organization solely dedicated to ensure the peg of UST. Additionally, they continued to push adoption of UST across the crypto ecosystem to pursue more organic demand for the stablecoin.
The LFG raised billions of dollars and used that money to buy Bitcoin in a fund: the Bitcoin Reserve Forex. This fund acts as the final barrier for when the stablecoin is in an extreme situation and falls below $0.98. In that case the Bitcoin is sold for UST instead of LUNA being minted in order to reduce the supply of UST on the market.
What has happened?
With this context in mind it will be easier to explain what has happened to the value of UST that should be fixed at $1.
Over the weekend, but it persisted on Monday, panic started to spread within the crypto space. Both Bitcoin and the stock markets were correcting heavily and taking down altcoins with them. There were already quite some concerns regarding the stability of the deposits on Anchor. In total over $10bln in stables were parked there for the lucrative yield offered by the platform. People were arguing that there could be a bank run once confidence was lost in UST and Anchor depositors would exit their positions.
Well, this is exactly what happened and already over 50% of the deposited stables on Anchor left the platform. These stablecoins were then sold for other digital assets, causing a discrepancy between supply and demand, and ultimately brought UST below the fixed value of $1. It even went as far as $0.60 on central exchanges because of the selling, lack of trust, and the stabilizing factors not able to keep up with the market.
The stabilizing factors would arbitrage by minting LUNA and taking UST out of circulation, however, because LUNA was decreasing rapidly in value itself this was not worth it.
As UST initially lost its peg, the LFG was forced to use their BTC reserves to act as a safety barrier. There are not many details available on how much has been used, because their holdings were transferred to central exchanges and market makers. It was little too late as UST is still struggling to maintain peg and is still trading below $0.90.
A situation many feared was brewing, actually unfolded over the past couple of days: a bank run on Anchor. The bank run paired with extreme negative market sentiment led to the collapse of the UST stablecoin which is still struggling to hold the dollar peg.
Terra Form Labs, LFG, and their partners have a huge interest in keeping UST as close to $1 as possible. The Bitcoin Reserve that was funded for this situation has been deployed and it brought some confidence back in the market.
During all this happening over 50% of the staked UST has left Anchor, but still $6bln worth is sitting on the platform. It is hard to say whether they are waiting for a higher value to exit or if they are actually confident in Luna and UST recovering and are maintaining their position.
Best case scenario for now is to have the markets calm down and the Terra teams to restore the peg above $0.90. As volatility decreases, then the stabilizing mechanisms could do their work again and bring UST back to $1. This will take time though and sentiment indicates that a lot of people lost confidence in UST.