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Stablecoins: behind the UST and LUNA collapse that shook markets


May was one of crypto’s most turbulent months in recent memory. A significant contributing factor to the market movements was the UST and Luna collapse. TerraUSD (UST) was pegged at $1 and started to depeg on 9th May at 18:00 UTC. By the end of the month, the price was $0.024. Bitcoin fell to a low of $26,800 while ETH went as low as $1,750.

The significant crash in TerraUSD, which was backed only by LUNA through an arbitrage algorithm, has prompted people to consider the future of stablecoins more generally.

What are stablecoins?

A stablecoin is a type of cryptocurrency that is tied to real-world assets like the US dollar. There are precious metal-backed stablecoins but the most common tend to be fiat-backed stablecoins, which are underpinned by government-issued currency.

Then there are algorithmic stablecoins pegged to a government-issued currency which are usually backed by crypto assets and not the currency itself. Such an algo stable uses algorithms to keep the value anchored to the value of the currency it represents. For example, when the price of the stablecoin deviates from its target price, the algorithm arbitrages the price discrepancy by buying or selling a certain amount of tokens to re-establish its peg.

Traders tend to buy stablecoins which are accepted on crypto exchanges and these are then used to buy and sell other cryptocurrencies more quickly. Tether is the largest stablecoin – it is pegged on a one-to-one basis with the US dollar and it says it is fully backed by its reserves of assets which include US government bonds, corporate debt and a small amount of cash.

What made TerraUSD different?

Where TerraUSD differed was that it was backed by the coin LUNA rather than actual US dollars. The algorithm would adjust the supply of Terra USD via Luna through open market operations, supply burns and mints, to keep its value pegged to the dollar.

This stopped working when Luna’s value plunged to near zero, adding pressure to an already tumultuous time in the market for cryptocurrencies. As a result, traders and investors rushed out from Anchor Protocol where the vast majority of the UST supply was sitting before the catastrophic event. Anchor Protocol is a platform created by Terraform Labs, the company behind the token.

Moreover, Terra had a reserve fund of around $3 billion in bitcoin and other cryptocurrencies, which is owned by Luna Foundation Guard, a non-profit co-founded by Terraform founder Do Kwon. Now, the Seoul Metropolitan Police Agency has said it has launched a probe into allegations that an employee of Terraform Labs embezzled an undisclosed amount of the company’s Bitcoin holdings.

The probe comes after the Seoul Southern District Prosecutors’ Office launched an investigation in late May into two collective complaints filed on behalf of a total of 81 investors over allegations that “Terraform founders and the company deceived investors with their flawed algorithmic coins”, according to the documents.

Confidence in the TerraUSD (UST) stablecoin peg evaporated causing several large withdrawals from Anchor, the Terra-based DeFi protocol that offered yields up to 20% to UST depositors and created demand for the stablecoin and its sister coin, LUNA.

To mint UST to deposit and earn yield, the algorithm had to burn an equal amount of LUNA. This led to the rise in the value of LUNA but when UST sold off, more LUNA had to be minted to keep the peg, leading to hyperinflation. The supply of LUNA was 343.23m on 9th May. By 25th May, the supply had grown to 6.53T, with the price of LUNA collapsing to $0.0001014.

On 12th May and triggered by the Terra depegging and the macroeconomic conditions, the liquidation of leveraged traders hit $1.22 bn, the highest since January, as Bitcoin fell to $26.7k, and the crypto market cap slid by 16%. Short positions liquidated around $300m while long positions liquidated around $900m. Positioning was long and traders were carried out on contagion from the Terra turmoil as it was expected that the Luna Guard Foundation would dump its BTC reserves on the market to defend the stablecoin.

The number of Bitcoin addresses in the money, meaning those that acquired their holdings at prices below today’s, reached lows not seen since March of 2020 after achieving dizzying heights last year. The level, currently hovering around 51%, “points to capitulation,” though bear markets in 2015 (30%) and 2018 (45%) saw even lower lows.

BTC ITM addresses

Stablecoin supply also fluctuated massively at the back end of May. Across the month, the supply of USDC increased by 4.75bn USDC. In the same period USDT fell by 9.94bn USDT and DAI fell by 1.3bn DAI.

What has been the effect on the wider crypto market?

A by-product of the algorithmic stablecoin turbulence was de-risking and net reduction in stablecoin exposure, with centralized Tether (USDT), viewed as the riskiest, facing almost $10 bn in redemptions as it briefly lost its peg. Centralised stables like USDT and USD Coin (USDC) are pegged 1:1 to the USD and are meant to hold reserves to back each coin, but Tether has the lowest exposure to cash and cash-equivalents.

Tether, the world’s traded stablecoin in crypto, has seen large price fluctuations this month. The unravelling price of TerraUSD caused a wobble in the price of USDT on 12th May. It has previously gone through some instability in 2018 and 2019, dropping to $0.94 and $0.93 respectively. $3bn worth of UST were redeemed in a single day as traders worried about the quality of Tether’s reserves, even though it is not an algorithmic coin, but the system withstood the test.

Elsewhere, NFT sales have been trending down across the year. However, the sales spiked to $750m on 1st May due to the Otherdeeds NFT mint. There was also a spike in decentralised exchange activity as Terra imploded. More tempered activity as users are cautious has translated into low gas fees on the Ethereum blockchain, which dominates both NFT sales and DEX volumes as competition for blockspace is reduced.

Emiliano Bruno is a Research Analyst at BEQUANT, the digital asset prime brokerage and exchange platform.  

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This article does not constitute investment advice. Make sure you do your own research or consult a professional advisor.

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