Luna Foundation’s UST failed to hold its value against the USD, bringing into question the viability of such stable coins
If there is one word that could sum up the recent financial market action, it’s Volatility. The markets have seen huge swings in the past couple of weeks as investors come to terms with the macroeconomic realities, supply chain problems and evolving geopolitical conditions. Stocks across the globe have taken a hit, dollar peers have caved against the reserve currency & cryptos have plummeted. And if this was not enough for the cryptocurrencies, the digital assets space is now confronted with another conundrum.
Ironically, the problem got triggered by one of the biggest stable coins in the blockchain ecosystem. Stable coins are basically digital tokens that are created to solve the volatility & stability issues with traditional cryptocurrencies. The culprit, in this case, is UST (TerraUSD) — an algorithmic stable coin that automates the process of pegging to the US dollar without the need for collateralization.
The model is designed to balance the supply and demand for UST. When the price of UST is too high, users are incentivized to burn its sister coin LUNA and create new UST — increasing the stablecoin’s supply while also decreasing the amount of LUNA in circulation. As a result, it becomes more scarce, which makes it more valuable, transferring that value into UST. When UST’s price is too low, the reverse happens — UST gets burned and LUNA is minted. That should, in theory, help stabilize prices.
Figure 1 — Daily Chart of LUNA/USD
However, there is a caveat. This process works under normal market conditions. During periods of high volatility, as we have seen in recent times, the above mechanism is not enough to maintain price stability in the face of one-sided buying/selling. And this is exactly what started to happen over the weekend when UST’s price initially fell to 99 cents to the dollar. Although the viability of this economic model had already been put into question in previous “de-pegging” events, things went too far this too time.
Crypto Special Podcast on the Luna saga
In a desperate attempt to save the peg, Terra’s inventor Do Kwon, said that the foundation would lend $750 million worth of bitcoin to trading firms to “help protect the UST peg,” while a further 750 million UST will be lent out to buy more Bitcoin. Kwon believes that BTC could eventually become the reserve of the Terra ecosystem. As is the case, a total of $3.5 billion worth of Bitcoin bought to provide a backstop for UST in times of crisis has only backfired. The huge slippage in BTC price exacerbated the move.
“[With stablecoins,] we see run risks, which could threaten financial stability, risks associated with a payment system and its integrity and risks associated with increased concentration if stablecoins are issued by firms that already have substantial market power.”
~ Janet Yellen, U.S Treasurey Secretary
On Monday, the value of UST plunged to as low as 69 cents, causing a swathe of investors to liquidate their holdings. Things recovered somewhat on Tuesday, before it tumbled below 40 cents overnight, causing widespread panic. Already rattled crypto markets, are now grappling with contagion fears, as the world’s largest crypto exchange Binance, discontinued LUNA and UST withdrawals for approximately six hours on Tuesday.
Financial regulators already have been highly skeptical of cryptocurrencies, but now seeing one of the biggest stable coins crumble like this has certainly raised some eyebrows. On Tuesday, U.S Treasury Secretary Janet Yellen said the de-pegging of TerraUSD shows the urgency to have a regulatory framework on stable coins.
Terra’s LUNA was bearing the brunt of market turmoil as it dived a staggering 80% in just 24 hours — more than 95% within a week (Figure 1 above). At the time of publishing, UST is trading at $0.310 — down almost 70% from its peg amount. One can’t help but wonder, how this is going to affect the broader crypto market once things settle down. For now, investors panic as a controversial crypto experiment unravels.
Originally Published on Medium
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