Over $5 Billion of deposits in the Anchor protocol vanished (5/9) as the Terra algorithmic stablecoin UST lost its pegging to the US Dollar (USD). The value of the deposits fell from $14 Billion to $8.7 Billion, as holders pulled out their UST from the protocol as the price peg fell below $1. At one point in time the value of UST had fallen to as low $0.7003 (as of posting) with no relief in sight. That means if you had $1,000 of UST locked in the protocol, your money would now be valued at $700. That means you have lost 30% of your deposit (not including any yields from interest), or $300. Since UST is a stablecoin, it should have little to no volatility so this is a collapse in the peg.
This chart shows the sudden plunge of Terra USD (UST) in the past 7 days. (Source: Coinmarketcap)
UST is an algorithmic stablecoin which is not actually backed one-to-one by a commodity or asset. Although it is pegged to the USD, It must maintain its price through the creation and burning of its supply with another token. In this case it is with Terra's LUNA token. In order to mint or create UST, users must purchase and burn LUNA tokens. If I want to mint $50,000 worth of UST, then I need to first purchase LUNA and then burn the tokens to get the UST. They are interconnected, so you cannot create UST unless you burn LUNA. You can also swap other tokens for UST on exchanges or a DEX, but you cannot create UST from other tokens.
Let's take a look at how Terra designed the relationship of UST and LUNA. Since UST lost its pegging, it has also affected LUNA prices. LUNA fell by 50% on Monday (5/9) as the overall cryptocurrency market also started to fall. As the value of UST fell, holders began to have a crisis of confidence and began to withdraw their UST deposits, mainly from the Anchor protocol. When the value of UST is above $1 (demand > supply), the protocol incentivizes users to burn LUNA and mint UST. However when UST is below its peg (demand < supply), the protocol incentivizes users to do the opposite, burn UST and mint more LUNA. This is supposed to prop up the price of UST until it returns to its USD pegging.
The protocol was built with mitigation measures, but not disaster prevention. The problem is that more users were withdrawing their UST, akin to a "bank run". It becomes a net negative for both tokens. As more investors dump their UST, the total value in the protocol plunges. This increases the supply of LUNA, but that also lowers the price of the asset. The main issue is that it was not able to offset the UST depegging from the USD. There was just not enough liquidity to correct the problem, and this has led to the collapse. This has also affected a third token, ANC, which is the governance token of the Anchor protocol. The price of ANC has fallen by 35% after the UST chaos unfolded.
The total deposits in Anchor have fallen as UST depegs from the USD (Source: Anchor)
As of writing, the price of UST has not returned to its peg. It appears to be going lower and it is creating more fear in the market. In the past, critics have called out the Anchor's mechanism for high yield rates as unsustainable. This is because interest generated from borrowing money from depositors cannot cover payouts. The "Do Kwon Pump" was meant to address the problem of liquidity in the ecosystem with reserves in Bitcoin. This is handled by the LFG (Luna Foundation Guard), which announced that they are going to lend money from their reserves in BTC to stabilize the peg. That means either borrowing capital against their reserves in Bitcoin, or selling BTC to replenish UST.
This is a warning sign for those who put money into earning or high yield protocols. At times of extreme FUD and volatility, like what is happening in the start of the 2Q in 2022, the protocol will be tested. Terra and Anchor were both designed with good intentions, so they are not trying to scam or rug pull people. What happened is the protocol was not able to remain stable. Critics would further say that the system may not be sustainable during the worst moments of market volatility.
The DeFi space is a myriad of new systems that have not been fully verified as tried and true, so this whole industry remains risky for the average investor. On another note, this incident could very wall lead to new calls for regulation of stablecoins. Regulators will be wary that incidents like this (they have happened before) can affect many users losing money. Right now Terra is going to need some emergency funding, which could come by way of investors like Alameda (Sam Bankman-Fried and company). Hopefully it can be resolved and the lesson learned from this can help protocol developers build better systems.
Photo Credit: Andrea Piacquadio
Disclaimer: This is not financial advice. The information provided is for reference and educational purposes only. Please DYOR to verify information.
