In the second week of May all hell broke loose in the crypto market as Terra's UST and LUNA tokens, as well as its decentralised finance platform, Anchor Protocol, went spiraling out of control. Crypto pundits have always maintained their decentralised blockchains do not have the weaknesses of regulated central banking systems. Yet what happened to Terra was akin to a bank run in the fiat economy. And in the unregulated crypto universe, there is no lender of last resort to stop the run.
What is UST and LUNA :
Terraform LABS (Terra for short) from South Korea owns the Terra blockchain. Luna Foundation Guard (LPG), which is Singapore-based, is the governing body for the development of LUNA. Both LUNA and UST are tokens issued by Terra. UST is a stablecoin. LUNA is the native token on the Terra blockchain. 'Native' means it is the base token on a blockchain, and which is also used to settle transaction fees. LUNA also serves as the treasury token that enables UST to peg to USD to maintain 1:1 parity.
What are stablecoins :
Stablecoins are tokens which are pegged 1:1 to fiat, mostly USD. That means the tokens have backing, somewhat similar to MAS using the foreign exchange reserves to back the SGD. The difference is SGD is not pegged to anything.
Stablecoins are differentiated by the way it is collaterised:
1. Stablecoins backed by reserves in fiat (bank deposits, bonds, other securities, held by custodians). The assets are off-chain. Eg Tether (USDT) and Circle & Coinbase (USDC).
2. Stablecoins backed by other tokens, i.e. the collaterals are on-chain. Eg MakerDAO's stablecoin DAI is collaterised by Ether (ETH).
3. Stablecoins backed by another native token and an algorithm controls the relationship between the two such that the stablecoin is pegged 1:1 to fiat. This is call an algorithm stablecoin.
Type (1) are known as centralised stablecoins. (2) and (3) are decentralised, which means the mining function underlies their mechanism.
Why stablecoins are important in crypto ecosystem :
Because they are pegged to fiat, stablecoins are not volatile. They serve 2 very important functions -
* When trading cross cryptos and there is no such pairs in the exchange, stablecoins provide the liquidity for the trades. Eg if users want to move from crypto XXX to crypto YYY and there is no XXX-YYY pair, users can do UST/XXX and then a UST/YYY trades. This avoids the necessity of using a fiat go between which is slow and expensive.
* Stable coins allow players to park their cryptos if they want to remain in the market but temporarily inactive in trading, ie when they want to sit it out for a while.
The demand for stablecoins has seen UST grown in a matter of 2 years to the 4th highest traded stablecoin token with a market capitalisation of US$15B.
What is arbitrage :
A profit opportunity exists when a product is priced differently in 2 markets. Eg if 2 oranges cost S$1 in Singapore and in Johore Bahru the equivalent of S$1 can buy 3 oranges. Buying the oranges in JB and selling in Singapore gives an arbitrage profit. The relationship between UST and LUNA is driven by the investment strategy of arbitrage.
How UST maintains 1:1 peg to USD :
An algorithm is simply some codes to execute a process. It is on auto-mode. This algorithm works dynamically to make sure the UST hovers very near 1:1 rate to USD.
The price of UST is a function of supply and demand. If demand rises, its price increases. When supply increases, its price falls. Terra allows users to swap between UST and LUNA at a guaranteed price of US$1.00 for each UST. In other words, users can swap 1 UST for US$1.00 worth of LUNA.
* When the price of UST rises, say to US$1.03, users swap LUNA for UST. At whatever the market price of LUNA, if the user swaps say US$1.00 worth of LUNA, then he receives 1 x UST. What is the impact of this?
1. The LUNA traded in are destroyed, in crypto language, 'burnt', and new UST mined or 'minted'.
2. Users receive from Terra 1 UST @ US$1.00 which they can sell at market price of US$1.03 thus making an arbitrage profit US$0.03.
3. As more users take advantage of the arbitrage opportunity and swap LUNA for UST, the supply of UST increases. As supply increases, the price of UST will decrease till it reaches parity with USD again.
4. Meanwhile, as LUNA are burnt. its supply decreases and its price increases.
* When the price of UST drops, say to US$0.95, users swap UST for LUNA. At whatever the market price of LUNA, if the user swaps say 1 x UST (at whatever its price), then he receives US$1 worth of LUNA. What is the impact of this?
1. The UST traded in are, 'burnt', and new tokens of LUNA are 'minted'.
2. Users swap 1 x UST @ US$0.95 (discount) for US$1.00 worth of LUNA thus making an arbitrage profit of US$0.05.
3. As more users swap UST for LUNA, the supply of UST decreases. As supply decreases, the price of UST will increase till it reaches parity with
USD again.
4. Meanwhile, as more LUNA are minted. its supply increases and its price decreases.
Note the UST/LUNA relationship:
* To manage the price of UST up, the price of LUNA is forced down.
* To manage the price of UST down, the price of LUNA is forced up.
* Terra cannot protect both UST and LUNA at the same time.
In summary, algorithm stablecoins work on the basis of mint and burn of the coin and its native token, using the arbitrage motivation for the market to re-establish parity with the fiat.
Bitcoin (BTC) backing for LUNA :
Algorithm stablecoins is a relatively new concept. To allay risks, the LPG made a policy announcement in Feb 2022 to build a reserve holding of US$10B worth of BTC to back LUNA. This is of course a positive development. Some sources put their current BTC reserves at US$3.5B. This will also mean the price of LUNA will be sensitive to BTC volatility.
Terra's Anchor Protocol :
Anchor is Terraform LAB's DeFi (decentralised finance) protocol built on top of the Terra blockchain. Anchor allows users to deposit UST into a pool for lending out. Practically every DeFi offers a dynamic rate based on demand-supply. Anchor offers a fixed rate of close to 20% annualised percentage yield (APY) to depositors. Revenue is from interest charged to borrowers, stake rewards on loan collaterals (other tokens), and redemption fees. Excess revenue after paying depositors' interest is retained in a Yield Reserve to be tapped in future periods of negative net revenue.
The big picture was clear. A fixed 20% APY is not sustainable and the Yield Reserve will be depleted very fast. In March 2022 the LPG announced a change to the rate. It was to be refixed monthly. If the Yield Reserves drop by 5%, the rate will be reduced by 1.5%. This was not good enough and in May 9 the LFG proposed a rate cut to about 4%.
The collapse of UST and LUNA :
What happened in that tumultous week? Was it an attack by crypto whales, or was it a black swan event? The answer is most like a convergence of several factors.
The Fed battles inflation
The era of cheap money comes to an end as the Fed grudgingly takes meaningful steps to fight Bidenflation. US is having an inflation rate of 8.3%, the highest since Jimmy Carter's disastrous years. Market expectation is interest rates will be raised from 0.2% to 2.75% by the end of the year. On May 4, the Fed raised rates by 50 basis points, the highest in 40 years. Another 4 rounds of similar increases is expected up to year end. The Fed has also announced it will reduce its balance sheet drastically with Quantitative Tightening. It will start disposing US$30B of securities per month commencing June. The effect is a decrease in liquidity in the fiat economy
This has great impact on the high leverage investment gamers in the financial markets, including cryptocurrencies. Investors will start to restructure their portfolios and valuations will go down.
Bitcoin performance
As the pre-eminent token, BTC movements has a psychological impact on the crypto market.
Following the Fed announcement May 4, BTC has sheded about 25% from the 40,000 range to current 31,000. This impacts LUNA's BTC reserves holding and thus its price.
Exodus from Terra Anchor Protocol
Data shows as much as 70% of UST issues were locked away in the Anchor Protocol. It means investors were simply buy-and-hold players. Buy UST and deposit in Anchor to earn the high 20% interest. When the LPG decided to reduce the interest rate in March, the raison d'etre for UST vapourised. Depositors exited in droves and Anchor collapsed.
To get rid of the UST, investors will want to swap it for LUNA and move to other cryptos or ramp-off to fiat. This resulted in the burning of UST and minting of LUNA. As more and more of LUNA tokens were minted, its price tanked.
The burn and mint mechanism cannot cope with the sudden increase in transactions and the system had to pause withdrawals many times.
Desperate UST holders have another avenue to dispose of the token. Seasoned players move to Circle Finance, another platform which has a stablecoins pool. This allows users to swap one pegged stablecoin with another. Eg UST can be swapped to Tether (USDT) or Circle's USDC. As UST tokens poured in, soon the pool's stablecoins became severely mismatched. There were simply too many UST vs the other stablecoins in the pool. In order to promote the swap. UST had to be offered at discounts. Due to poor take up, the discounts grew larger and larger, and UST price tanked.
Crypto whales at it again
The foreign exchange market is so huge it is quite impossible for a single speculator to influence it. The crypto market is not that big. Crypto whales are investors who hold large positions and whose actions can affect the market. Whether they are attacking the market, or simply making legit investment decisions, who knows.
On May 8, an investor swapped 85,001,010 of UST for 84,509,387 USDC at a small 0.6% discount. This probably unnerved the market and UST began to depeg after this.
What are reserves for
By May 10 UST had depegged to 0.64 level. Terra deployed its reserves of Bitcoins to mop up the USTs flooding the market. For a while this worked and UST moved back again to 0,94. But it was not enough and UST slipped down. As the saying goes, no one is big enough to go against the market.
Black Swan event
This is an event that is unexpected and which creates severe consequences. According to Terra CEO Do Kwon, the algorithm for the burn and mint to manage the UST-LUNA arbitrage transactions could not be executed fast enough to get ahead of the market and return UST to its 1:1 peg. The codes can be revised to improve the system.
Conclusion :
Like many crypto failures before them, Terra's technology were brought to the market without serious stress testing. This is the problem of an unregulated market. Whilst many crypto billionaires have seen their net-worth dropped severely during the week that was, it is the retail investors who are hurt the most, Many have had their life-savings wiped out. The tragedy is that many retail investors probably do not even understand the complexities in the UST-LUNA-Anchor relationships.
Confidence has been shaken. Will the trio of UST-LUNA-Anchor go to the graveyard of failed cryptos?
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