The News: Terra’s not-so stablecoin UST collapsed and exposed the worst of crypto. The supposedly dollar-pegged algorithmic “stablecoin” UST dramatically fell from $1 per token to under 70 cents per token early last week before continuing its decline to under 12 cents as of the time of writing. The crash resulted in over $40 billion in losses for Terra ecosystem token holders. Read CNBC’s reporting on the collapse here.
Terra’s Not-So Stablecoin UST Collapses Resulting in Over $40 Billion in Losses
Analyst Take: Terra’s algorithmic stablecoin UST isn’t so stable after all. The value collapsed and trading has been suspended on many major exchanges. The Terra blockchain itself has been suspended, effectively freezing the ability to convert UST back into its underlying collateral. In short, Terra blew up.
The collapse has renewed calls for a terminology change for which this analyst has long advocated – stop calling using stablecoin to refer to algorithmically pegged, collateralized short-term liabilities. That’s a mouthful, but it brings significant clarity to what UST actually is.
The Underlying Mechanism for Terra’s UST is a Ponzi, Sort Of
The mechanism to peg UST to $1 is as straightforward as it is absurd. UST has a sister asset, Luna. When UST is worth $1.01, code on the blockchain creates new UST and sells it in exchange for Luna. When UST is worth $0.99, the code does the reverse – it creates new Luna and sells it in exchange for UST. Straightforward supply and demand.
This model only works if people are willing to buy and hold UST and Luna. Terra agreed to pay UST holders a 20% yield – paid out in Luna – for loaning UST. That’ll work if enough people believe it works. Faith was good enough to get UST to $18 billion outstanding before the collapse.
If you squint, you can see the sort of Ponzi scheme. In a Ponzi, investments from new investors are taken in to pay interest to existing investors. There are never enough assets to pay back all investors at once. A Ponzi typically fails when new investors stop investing, existing investors demand their money back, and it’s revealed that there aren’t enough assets.
This sort of looks like a Ponzi: UST is only valuable if people keep buying Luna and if everyone holding UST wanted to redeem at once, the price of Luna would collapse and the UST dollar peg would break.
But Terra did something that moved it away from being a true Ponzi – it bought bitcoin to back UST.
UST Was Backed by Luna and Bitcoin, Which Ultimately Led to Its Undoing
In January of this year, Terra’s founder, Do Kwon, announced that he was setting up the Luna Foundation Guard to purchase bitcoin and help maintain the UST dollar peg.
Functionally this meant additional collateral to back UST – when UST moved off its peg, the Foundation could exchange Luna or bitcoin as necessary. At its high-water mark, the Foundation owned over $3 billion of bitcoin.
The problem is that sets up a very attractive arbitrage opportunity. Bitcoin is a relatively liquid market – it’s possible to borrow hundreds of millions of dollars in bitcoin. A firm that wanted to wreak havoc could use UST to make money shorting bitcoin, that is to say, make money as the price of bitcoin falls.
The strategy could play out as follows:
- Borrow a lot of bitcoin
- Purchase a lot of UST
- Dump both on the market – sell huge volumes quickly to drive down the price of both assets
- The Foundation will be forced to create more Luna to maintain the UST dollar peg and sell bitcoin, just as the price is falling
- That will drive the price of bitcoin down further, sparking, panic, more selling, and further price declines
- Buy back the now-cheaper bitcoin to pay back the loan and pocket the proceeds
We don’t have hard evidence that such a trade was executed, but it’s both plausible and would have been highly profitable. A similar trade is what Soros executed in 1992 when he famously “broke the Bank of England.” Copy-cat trades led to the Asian Financial Crisis later that decade.
Employing the same broken design for a “stablecoin” is an unforced error.
Treasury Secretary Janet Yellen Calls for Regulation in the Wake of UST
Treasury Secretary Janet Yellen happened to be testifying before the House Financial Services Committee as the UST collapse unfolded. She took the opportunity to repeat her call for greater regulation of stablecoins: “I wouldn’t characterize it at this scale as a real threat to financial stability, but they’re growing very rapidly and they present the same kind of risks that we have known for centuries in connection with bank runs.”
With such statements, it looks like stablecoins of all types may soon be painted with the same brush. It’s an outcome I find disappointing – I reject lumping UST and true stablecoins like USDC and USDP into the same bucket.
UST was a flawed design. Even after the Foundation purchased $3 billion of bitcoin, it was at best a partially-collateralized short-term loan. Such activities belong in the banking sector.
USDC and USDP are backed entirely by cash and short-term US treasuries stored in segregated custody. They look a lot like money market funds, an instrument very clearly not part of the banking sector.
This isn’t to say how we should regulate these instruments, but rather that we need to go back to basics. We need to move beyond terms like “stablecoins” and begin to define what these instruments are using the already entirely sufficient vocabulary of financial services. Maybe at that point, we’ll begin to develop clarity on the risks and can avoid another unforced error like Terra’s UST.
Disclosure: Futurum Research is a research and advisory firm that engages or has engaged in research, analysis, and advisory services with many technology companies, including those mentioned in this article. The author does not hold any equity positions with any company mentioned in this article.
Analysis and opinions expressed herein are specific to the analyst individually and data and other information that might have been provided for validation, not those of Futurum Research as a whole.
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Image Credit: CSNBC
The original version of this article was first published on Futurum Research.
Jared is an Analyst in Residence at Futurum Research, where he helps guide our practice in all things Web3, the Metaverse, and cryptocurrencies so as to help business leaders understand how they work, why they matter, and how they can not only get involved, but become market leaders along the way.
Jared previously co-founded and served as President and Board Member of Triple Point Liquidity, a blockchain-based fintech startup serving alternative asset managers, their investors, and fund administrators. Prior to Triple Point, he held multiple roles at IBM including leading Digital Assets at IBM Blockchain, leading corporate development for Industry Platforms, and founding Watson Risk & Compliance.
Jared is author and podcast co-host at Fat Tailed Thoughts and serves as a trustee for The Williams School.
Jared holds an AB from Dartmouth College.