Amid the collapse of the cryptocurrency market, the Terra ecosystem algorithmic steblecoin – TerraUSD (UST) – again lost its peg to the U.S. dollar. On the night of May 10, the price of the asset fell below the $0.62 level.
Because of the incident, cryptocurrency exchange Binance temporarily froze the withdrawal of funds in the blockchain Terra.
It’s not for a lack of demand to bid below $.70. It’s simply not possible to submit orders via frontend/API. Dunno what’s going on
— Hasu⚡️🤖 (@hasufl) May 10, 2022
As of this writing, UST is trading near $0.92.
TerraUSD is one of the largest dollar-stablecoins. According to CoinGecko, its capitalization exceeds $16 billion. Since UST uses the LUNA native cryptocurrency burning mechanism to issue UST, the price of the two assets is closely correlated. Sergei Strutinsky, an expert in mathematical modelling said:
The existence of such a correlation creates significant inflationary risks arising from the withdrawal of Stablecoin from the Terra ecosystem. Such an examination of market processes shows that the withdrawal of a significant amount of UST from circulation does not affect the value of the latter thanks to arbitrage, but the operation stimulates a decline in the price of LUNA. In a downtrend in the market and in the presence of negative news, there may be a significant drop in the value of the cryptocurrency.
LUNA has lost more than 40% of its value in the last 24 hours and is trading near $36 as of this writing. Back on Friday, May 6, the cryptocurrency price exceeded $80.
The model of maintaining UST parity with the U.S. dollar relies heavily on arbitrageurs. If the price of Stablecoin falls below $1, traders can buy it and exchange it for $1 in LUNA, making a profit.
1/ To help others understand the $UST arbitrage and why the peg doesn’t come back straight away…
There are some parameters that determine the spread when minting and burning $UST / $LUNA. The more mint/burn happens in a day, the higher the spread. #terraluna
— My Life in Defi (@MyLifeInDefi) May 9, 2022
However, for this mechanism to work, there needs to be demand for the target asset. In the case of UST, the platform that provides such demand is Terra’s largest ecosystem protocol, Anchor. The latter pays over 19% APR on UST deposits.
According to SmartStake, users withdrew more than 3.3 billion USTs from the protocol on May 9. In less than 24 hours on May 10 the outflow of funds amounted to another 1.1 billion UST.
Users withdrew funds because the deposit rate was reduced to 17.87%. On May 8 this led to a brief loss of the UST peg to the U.S. dollar. But already on May 9, the rate returned to 20% – against the background of the outflow of funds Anchor found it easier to pay higher interest rates.
At the same time, the volume of the yield reserve continues to decline. At the time of writing, there are less than 180 million UST in the pool.
Bitcoin Reserves of LFG
In March 2022, UST got another sustainability mechanism, the Luna Foundation Guard (LFG) bitcoin reserve fund, a nonprofit organization. It should promptly provide the liquidity necessary to maintain the price of the asset in BTC. As early as May, the entity’s assets under management reached 80,394 BTC.
Aztec project growth head Jonathan Wu noted that the decision to create the fund was made after the incident with the Abracadabra Money platform. The latter allowed to use of UST to issue Magic Internet Money (MIM) with a collateral ratio of up to 90%.
This was all challenged in January when Degenbox collapsed.
That implosion took down a big push for $UST to be used in a 10-figure cross-chain ecosystem headed by Daniele Sesta.
That’s when Jump, 3AC, and others piled into the $1 billion Luna OTC deal to buy Bitcoin.
— jonwu.eth (@jonwu_) May 9, 2022
In January 2022, a scandal erupted around the Wonderland DeFi project, with which Abracadabra Money founder Daniele Sestagalli is associated. The incident led to a decline in the value of LUNA (cryptocurrency price plummeted 21% in a week) and the temporary loss of UST’s peg to the U.S. dollar.
Against the backdrop of the May 9 events, LFG announced that it would provide a $1.5 billion loan to OTC traders to ensure the stability of TerraUSD. Funding was allocated through the sale of reserves in BTC.
Shortly thereafter, the organization published its new bitcoin address and noted that it would continue lending to market makers.
Below is the new LFG $BTC wallet address: https://t.co/9t0NX3VEMI
Last clip withdrawn by the LFG was ~37K BTC. Similar to the last deployment, it has been loaned to MMs.
Very little of the recent clip has been spent but is currently being used to buy $UST.
— LFG | Luna Foundation Guard (@LFG_org) May 9, 2022
Onchain data shows the emptying of the LFG wallet. According to the organization’s dashboard, there are ~$197 million in assets left in the reserve fund – the lion’s share of the funds are in LUNA, UST and AVAX.
LFG governing board member Jose Maria Macedo in a conversation with CoinDesk stressed that the reserve funds would be enough to restore a stable UST price. Critics of the organization, however, believe that it has merely “bought another day of time.”
LFG using market makers to stabilize UST is fine imo. They were going to monetize their treasury one way or another. It buys them some time but it’s too little, too late. Optimistically it buys them a week. Pessimistically, less than a day.
— Galois Capital (@Galois_Capital) May 9, 2022
The Block analyst Larry Chermack noted rumours that Jump Crypto, Alameda Research and other organizations supporting the Terra ecosystem have committed an additional $2 billion “to bail out UST.” In his opinion, the only way to save the asset is to make it fully collateralized.
I personally think the only way to save it now is by fully (or potentially very close to fully) collateralizing. Otherwise I don’t see it ever being used again
— Larry Cermak (@lawmaster) May 10, 2022
The network also pointed out that Alameda Research has issued more than 3.4 million UST on the Near blockchain. Users suggested that the smart contract platform could launch a profitable farming program.
👀 Lord Sam (Alameda) just minted around 3.4M $USN with approx ~300K $NEAR.
It may sound peanuts but imo it’s just a start, since they’ve minted it I’m assuming USN Yield might be just around the corner😉😗 pic.twitter.com/esWkUqzzcN
— SankΞt Ⓝ⚡️| sanketn81.near, sanketn81.eth (@sanket_naikwadi) May 9, 2022
The head of Terraform Labs, Do Kwon, stressed that LFG has no plans to “give up its position in bitcoin.” He explained that transferring capital to market makers would provide liquidity that would stabilize UST.
2/ First, *LFG is not trying to exit its bitcoin position*.
The goal is to have this capital in the hands of a professional market maker such that:
1) Buy UST if price < peg
2) Buy BTC if price >= peg
thus significantly strengthening the liquidity around UST peg
— Do Kwon 🌕 (@stablekwon) May 9, 2022
Jonathan Wu also suggested that market makers are “willing to do whatever it takes to prevent a UST death spiral.” According to him, the outcome of the situation will depend on whether market makers’ selling pressure is exceeded by retail traders.
So what’s next?
Friendly marketmakers go to work on deploying a piece of the $BTC treasury to market-buy $UST and keep the peg up.
Hope is there’s more (falling-knife) $BTC collateral in LFG than there is bank-run pressure from people fudding $UST.
— jonwu.eth (@jonwu_) May 9, 2022
A popular analyst nicknamed Hasu noted that Terraform Labs and LFG had another possible strategy for action.
Hate to give tips to ponzis but I’d just let the peg break down, not burn the treasury trying to support it. Wait until UST supply <> treasury parity, then rebuild as a collateralized stablecoin
— Hasu⚡️🤖 (@hasufl) May 9, 2022
Meanwhile, Terraform Labs said sceptics exaggerated the significance of what was happening. The company stressed that UST is also secured by activity within the Terra ecosystem, and arbitrageurs need time to stabilize the asset.
2/ UST MCAP > LUNA — No death spiral happens.
— Terra (UST) 🌍 Powered by LUNA 🌕 (@terra_money) May 9, 2022
Some believe that the incident, regardless of the outcome, will have serious consequences for the cryptocurrency market. Blogger Dennis Porter noted that regulators will use the collapse of UST as a major argument for the total regulation of stablecoin.
Mark my words. The UST failure will be used as evidence by policy makers to regulate stablecoins to death and champion CBDCs.
This is not good.
— Dennis Porter (@Dennis_Porter_) May 10, 2022