The Fall of TerraUSD, The not so Stable Stablecoin

May 4, 2023

It has been a just over a month now since May 12th’s spectacular, industry shaking collapse of TerraUSD (UST). Now that the dust has somewhat settled, we thought we’d take a look back at how events unfolded, what caused the depegging of the what was supposed to be a stablecoin in UST and offer a glimpse into what the future might hold for stablecoin regulation.

TerraUSD and Luna — What Went Wrong?

In a nutshell, on May 12th 2022 TerraUSD(UST) experienced the modern day digital equivalent of a bank run. The result was a devastating death spiral which saw UST, TerraLuna’s stablecoin, lose its peg, dropping from its intended $1 peg valuation to under $0.20 at its low.

As we’re sure you already know by now, this was largely caused by a collapse in the value of UST’s collateral coin, LUNA, going into price free-fall, plunging from $80 to $0 in four days. A spectacle if ever there was one, as onlookers watched on in disbelief as a top ten digital asset plummeted from its once lofty highs, to meets its grizzly demised — all play out in real time. The dropping like a stone of the value of the LUNA coin further compounded UST’s depeg, causing UST holders to rush for the exit and unload their remaining coins onto the market to try to claw back losses.

Source: https://coinmarketcap.com/currencies/terrausd/

In the immediate aftermath of the collapse of the two of the once most prominent digital asset projects, Crypto Twitter theories went into overdrive with some pointing to a deliberate attack perpetrated against TerraUSD by bad actors.

This turned out to be untrue. Or was it?

However conspiratorial this might seem, there does appear to be some truth to the bad actors theory as highlighted in a recent postmortem report by Nansen.

The report concluded that UST’s depegging was likely started by seven well-funded wallets within the Terra ecosystem itself. The report also stated that as the UST depeg was playing out, these seven identified wallets likely arbitraged inefficiencies between pricing on Curve, DEXs, and CEXs, compounding and worsening an already bad situation.

Not even a month before the meltdown, the organisation that managed the Terra ecosystem, the Luna Foundation Guard (or LFG) promised to raise $10 billion in bitcoin to fully secure UST in reserve, as a way to prevent a depeg/bank run style event from happening. This initially was met with great fanfare, but also a great degree of scepticism.

The sad truth of the matter is that had UST been fully collateralised and backed by bitcoin, a bank run would not have been possible. LFG’s bitcoin promise was never fulfilled and only $3.5 billion worth of bitcoin reserve was ever raised, resulting in Terra’s organisation being unable to back the high selling pressure against UST as the peg was lost.

What are Stablecoins? And what made TerraUSD Unique?

Digital asset stablecoins are a type of cryptocurrency pegged to a certain value of an underlying asset with the intention of, as the name suggests, keeping prices, well… stable.

The most popular stablecoin on the market right now is USD Tether (USDT), which is essentially a digital representation of a U.S Dollar with dollars being used as the underlying collateral. Theoretically, 1 digital USDT is of equal value to 1 real world US dollar. There are many other types of other stable coins out there backed by other assets, such as XAUT, pegged to the price of gold, and PTR, that was pegged to the price of oil.

The benefits of using stablecoins are three fold; users have the ability to send funds around the world without paying expensive wire fees; using them gives users the possibility to keep digital assets stable and free of volatility, and lastly; stablecoins offer a way to hedge digital currencies in a relatively safe and easy way.

TerraUSD was design to not be a centralized stablecoin pegged to one U.S dollar much like USDT or USDC, but UST was instead an algorithmic stablecoin. An algorithmic stablecoin keeps its stability by using an algorithmic system that buys the underlying assets when the price goes over the desired peg and sells these assets again when the peg falls below its peg valuation. Think of an algorithmic stablecoin as having its own built in arbitrage system written into very complicated and autonomous, self executing protocol.

In this instance, TerraUSD’s algorithmic price stability mechanism system was collateralised using the LUNA token. The mechanism worked by minting and burning LUNA tokens, where for every UST minted into circulation, a LUNA token would be ‘burnt’ or taken out of circulation. This mechanism should have have worked in theory. However the reality was that in early May 2022, the mechanism system put in place was unable to burn enough LUNA as and when UST’s peg began to breakdown, resulting in it becoming de-pegged and began to plummet in value.

How are stablecoins risky?

Digital assets such as UST and others rely heavily on the supply and demand dynamics of the free market to maintain their stability. Although generally considered as less risky and much less volatile than traditional digital assets like Bitcoin, the underlying risk that stablecoins do face resides in that if investors all want to cash out or swap out all at once, there is the possibility of a “bank run” or a “death spiral”, which has the potential to crash the stablecoin’s pegged valuation.

Source: @ZeMariaMacedo

The most infamous “bank run” in modern history occurred during the Great Depression of 1929. People tried to withdraw their money from the banks all at the same time, but the banks could not afford to redeem all this liquidity in one instance, causing the banks to go bankrupt and their clients to go bankrupt as well.

Stablecoin Regulation — What is it now and What is to Come?

Stablecoins represent a huge $162 billion segment of the digital asset industry, and this is growing year on year. These types of digital currencies are a prime target for regulators since they can be moved easily around the world and operate somewhat outside traditional finance and centralised controls.

There is, as of right now, no official regulatory framework in place by any government but many authorities around the world are now beginning to pursue this idea. We already know that stablecoins can be cheaper and easier to obtain, which does pose an existential threat to centralised global financial systems who are less than keen to see the establish fiat currency system threatened in any way.

In light of the LUNA/UST collapse, the U.S banking system is now pushing regulators to look quite seriously at regulating stablecoins to ensure retail investors do not again suffer huge losses and to ensure that stablecoins are sufficiently and correctly collateralised;

“What regulators are going to look for is companies issuing [digital] currencies backed by reserves. They’ll want to know that the issuer has those reserves and that the entity is stable,” Joshua White, an assistant professor of finance at Vanderbilt University.

What Regulation can we expect as a result of the TerraLUNA Event?

In the event of the TerraLUNA collapse, regulators will now likely be pressured to take some kind of action to ensure this type of situation doesn’t ever happen again. Afterall, the UST/LUNA meltdown cost the entire digital asset industry $40 billion in market cap which is a significant event not just for the digital asset sector, but also for the traditional financial systems as well. This event will surely prompt regulators to put rules in place to protect the investors against these sudden and dramatic falls.

Earlier in May 2022, U.S. Treasury Secretary Janet Yellen pushed for regulation during an annual testimony. This marked the first wave of rules entering the digital asset markets and could potentially become the standard for other types of digital currencies. Users of stablecoins and digital assets should be prepared for more legislation in the years to come as the digital asset industry continues to grow and mature.

How investors can protect themselves from a similar LUNA style event?

We thought we’d finish this post by offering up some practical information on what to look for when investing in any kind of digital asset:

Research and always do your own due diligence:-

By doing so, you’ll be able to find the right information to proceed with your investment with some degree of peace of mind. Investing in a digital asset requires a lot of research, so before putting any of your hard earned money into anything, research it thoroughly.

Deep dive into company or owner behind the project:-

This way you’ll need to learn more about the company that created the digital asset, and get an idea of the kind of pedigree, skills and expertise the team have. Consider paying attention to the team’s members and whether they can deliver what they promise — remember if something sounds too good to be true, chances are it probably is.

Be on the lookout for red flags:-

Find out whether this digital asset is decentralised, making sure you are always in control of your own keys is a key principle of monetary self sovereignty. Beware of pump and dump schemes — whereby group of investors promotes a digital asset and sell the asset once the price has risen, leading to a sudden slump.

Understand market trends by analysing charts:

It is important to look at longer-term trends and not just short-term ones. Learn how to read charts and trends with useful tools like Coinmarketcap. Just remember, the charts aren’t everything, sometimes price movements happen due to news events and project related announcements, which is why its really important to…

Stay up-to-date on the latest market and digital asset news:

As a result, you’ll be in the know of any potential issues that may positively or negatively affect your digital asset. Seeking to learn more will benefit your investment in the long run. And if you want to stay up to date with all the very latest news relating to bitcoin and digital asset industry, check out OTC’s weekly news roundups delivered every Friday!

Conclusion

TerraUSD’s depegging event has had a major impact all over the digital asset sphere, with stablecoins now being more closely watched than ever before by regulators. The Terra LUNA/UST depeg and subsequent meltdown serves as a humbling reminder that all that glitters is not gold, and highlights the importance of always carrying out due diligence when it comes to investing in digital assets. However, by following simple steps and taking a more thorough approach, we can train ourselves to invest in a more responsible manner and not run the risk of getting burnt.


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