UST Stablecoin Depeg - Will It Recover?
There is a lot of noise on Crypto Twitter these days around UST losing its peg and how that will cause doom and gloom for crypto as a whole.
It was even enough for the Federal Reserve to speak up about the event:
So will UST unwind or will it recover?
If you are already familiar with the Terra ecosystem you can go ahead and skip the introduction and refresher on how UST maintains its peg.
What is UST?
UST is an algorithmic stablecoin.
It’s different from a normal stablecoin in that it isn’t backed by any type of collateral, such as other over-collateralized or fiat backed stablecoins (such as USDC, USDT).
Because of UST’s success the Luna Foundation recently announced they will buy $10 billion worth of Bitcoin with their excess capital.
This did not however change the fundamental mechanism on how UST maintains its peg.
Why create an algorithmic stablecoin instead of a fully backed stablecoin?
Algorithmic stablecoins can deal with the real world problem of not having enough collateral to meet the demand for the stablecoins. Terra was the first protocol that came up with a reasonable solution to this collateral problem.
Decentralisation. Crypto always had an Achilles heel: All liquidity in the crypto ecosystem was dependent on centralised stablecoins (USDT & USDC). Arguably giving the crypto industry a single point of failure. Terra’s UST is the 3rd largest stablecoin by marketcap and is fully decentralised, which some deem to be one of the greatest achievement in cryptoland in the past few years.
UST historic performance
Historically UST has depegged for a short duration twice.
Once when the protocol was in its infancy and another time when it was under pressure during the BTC crash May last year.
So if they recovered in the past, why this fear?
For that we first must cover the basics.
So how does UST algorithmically maintain its peg?
Let’s look at two scenarios:
- Either UST is worth more than 1$
- or UST trades under 1$.
1. $UST < 1$ — below the peg:
The circulating money supply CONTRACTS within the system.
When UST’s price< 1$, anyone can give 1 UST to the system and they will get 1$ worth of $Luna in return.
So instead of selling your 1 UST(1$) for a loss in the open market (say 0.8$), you can just give it to the system for 1$ worth of $Luna and make a quick 20%.
The system burns the $UST obtained thus reducing the circulating supply, which increases the price of $UST.
The arbitrage opportunity incentivizes people because they can buy 0.8$ worth of $UST from the market and sell it for 1$ worth of $Luna.
Thus it’s dependent on market participants to bring back the pag.
2. $UST > 1$ — above the peg:
The circulating money supply is expanded within the system, which reduces the demand for the currency.
When demand for the currency falls, its price also falls relatively.
When $UST’s price> 1$, anyone can give 1$ worth of $Luna to the system and the system gives them 1 UST.
Then they can go to the open market and sell that 1 UST (which is worth 1$) for a profit (say 1.1$).
This also incentivizes people to give 1$ worth of $Luna to the system and get 1 UST back to make a profit.
Thus it’s dependent on market participants to bring back the pag.
Taken from @danku_r on twitter
THE PROBLEM — THE DEATH SPIRAL
The main problem with algorithmic stablecoins is their reflexivity by design.
LUNA absorbs the volatility of UST’s market: as UST goes above peg LUNA is bought and burned pushing LUNA’s price up.
And as UST goes below peg LUNA is minted and sold pushing its price down.
UST is not as decentralised as people think it is.
@Defi_made_here on twitter makes the case that if 74% of demand comes from Anchor Protocol because of it’s high stablecoin yield (~18% at the time of writing), it is inherently not decentralised.
Imagine a situation where Anchor Protocol is exploited and UST is sold on the market.
Taken from @Defi_made_here on twitter
Recently Anchor protocol moved from a static to a dynamic yield.
So instead of 20% it is being lowered over time with a minimum of 15% APY and will be reached in 2 months.
Now we are adding the launch of $USN and $USDD to the mix with their respective ~20% and 30% APY.
This could pose a problem as people will leave the terra ecosystem and move their $UST from anchor over to these new stablecoins with higher yield.
As UST is not backed by any collateral (aside from the BTC reserves) this could initiate a death spiral:
If demand for UST falls at Anchor Protocol, demand for UST falls.
As people sell UST → UST goes below peg → LUNA is minted and sold → LUNA supply increases means Luna price goes down.
This process is what is known as a “bank run” or a “death spiral,” and can be visualized below
Taken from @ZeMariaMacedo on twitter
There is not enough liquidity in the system to absorb all the UST.
So as an UST holder you have to understand the risk reward.
The Reward: 18% APY which is being lowered to 15% over time on @Anchor_Protocol.
The Risk: There is not enough liquidity in the system for everyone to exit at the same time.
Worst case scenario: Depeg and Death spiral
BETTING AGAINST TERRA?
Some big traders have bet and bet big against the algorithmic stablecoin:
ANALYSIS — Will UST Recover?
As I’m writing this UST is depegging to $0.84 on Coinbase and 0.82$ on Binance.
Let’s look at the reasons why UST will recover versus why this might signal the end for the Terra ecosystem.
Reasons why UST will recover from depeg
In the above tweet a number of explainer threads are given with reasons for why a repeg will occur:
- UST MCAP > LUNA — No death spiral happens.
- UST is backed by user activities on the terra blockchain and cashflow generated by such
- Understanding arbitrage and Peg regaining takes time
- Backed by VC’s that might jump in. The likes of 3AC, Jump, Defiance. Well known VCs in the space with very deep pockets.
- There are protocols like @teamkujira and @whitewhaleterra buffering Anchor Protocol liquidations and arbitraging the UST peg so there’s no liquidation cascade scenario.
- There is now a new mechanism added to the mix to defend the peg: BTC reserves
BTC reserves decrease the risk of a death spiral.
Because of reduced LUNA minting pressure. Instead there is now the option to swap UST to BTC instead.
As a side note:
There is some speculation that the Luna Foundation bought Bitcoin at 47k and then sold at 34k to defend its peg.
However that is untrue. Stablekwon, co-founder of Terra blockchain, explains:
Reasons why UST won’t recover from this
1) No exit liquidity -> Panic
There is $16.2 billion of UST left.
Peg defense reserves: $3billion of which they deployed 1.5$ billion
$Luna marketcap: $13.4 billion
Yes, there is a real possibility that investors panic. And the exit door becomes smaller and smaller.
Ever heard the saying:
“The market can stay irrational longer, than you can stay solvent.”
TVL on Anchor Protocol falling off a cliff as investors run for the exit
Even if investors don’t panic. The bottom seller doesn’t voluntarily sell, but gets a margin call.
Below is a case in point of an unfortunate trader getting liquidated for $225 million on a LUNA trade.
Looking at the open interest for LUNA perpetuals, there is about ~$600million in open interest right now. With funding being negative, meaning it pays to be long right now. That is about 4.6% of marketcap. For reference Bitcoin is ~1.7% open interest of marketcap.
An open interest of 4.6% is not that out of the ordinary for Crypto. But liquidation cascades are certainly on the cards.
2) Terra can’t find alternative demand for UST
Demand for UST is pushed by setting up a 20% subsidized, short-term interest rate. Previously around 70% of UST was locked in Anchor.
If capital rotation happens out of UST to $USN and $USDD because of better yields, UST could unwind via a bankrun.
25% of UST on Anchor (before the bankrun) was backed by BTC. Technically, it could do it through Luna, but in case of a run, it seems unlikely that investors would choose to move to Luna. The main driver of demand for Luna (and therefore UST stability) is future expected demand for UST. During the bankrun the sell & mint pressure on LUNA will prove to make Luna worthless.
The actual, real, long-term solution must be to grow the ecosystem. But in the short term it is unlikely that such an alternative is found.
Keep it simple.
For every 1 UST that needs to be redeemed for 1 USD there must be 1 USD (or any other non-Terra asset worth 1 USD) willing to either buy UST at a price of $1.00 or, due to Terra’s arbitrage mechanism, buy LUNA at whatever price.
If there are more UST looking to be redeemed than there is USD willing to enter the Terra ecosystem, UST can not maintain its peg.
At the end of the day if you go back to first principles you see the problem. If you’re allocated to Terra ecosystem then this is a bet that Terra’s founders will deliver and keep a good public image, a possible macro relief rally of Bitcoin, or rather limited downside and a hope that your average marketparticipant doesn’t stampede towards the exit door.
Personally, not financial advice, other than short term trades to take advantage of the volatility I don’t see an asymmetrical risk/reward scenario right now to allocate to the Terra ecosystem for the long term. Even though VCs might bail out UST, trust takes years to build and just moments to shatter.
What are the alternatives for stable coin yield?
Next we’ll dive into NEAR’s new stablecoin $USN and TRON’s new stablecoin $USDD.
And compare how safe or different their mechanism is from UST.