How is that size even possible? Afterall, $18 billion is more than the market cap of Coles! And it took Coles 108 years of hard work, blood, sweat and tears to reach that value. How did this algorithmic stablecoin, UST, achieve that in less than two years?
DigitalX’s research team recognised the risks to the Terra Luna ecosystem and its algorithmic stablecoin, UST, early on and rejected it as a viable investment in Q1 of 2022 – despite it fitting our Top 20 mandate.
DigitalX is a safe pair of hands for those wishing to participate in this emerging crypto asset class – be it as a Bitcoin exposure or through our actively managed fund which captures growth in the emerging Web3 sector.
The easiest way to understand Terra is to think of it like a traditional bank that facilitates payments, transfers, investments, loans and savings, but, with a key difference – this bank does this all in its own currency; not the USD or the AUD, but its own algorithmic stablecoin, UST, (referred to as TerraUSD). We’ll talk more about what UST is below.
Terra was founded in January 2018 by Daniel Shin and Do Kwon. Do believes that a decentralised world needs a native decentralised currency and is on a mission to replace centralised stablecoins like USDT, USDC. Terra’s goal is to have UST be the de facto stablecoin used in the crypto universe and even traditional e-commerce.
Algorithmic stablecoins use market incentives controlled by the algorithms to maintain a stable price against a currency such as the US dollar rather than backing the price with assets such as real USD in the bank account or treasuries.
There are several flavours of algorithmic stablecoins in the market – some are partially backed by real assets and some are literally created out of thin air. Needless to say, these are fascinating experiments in financial engineering.
But… how does it work? You can’t just create a coin out of thin air and claim that it has the same value as one real USD – how is the peg maintained?
This is where we get into how LUNA and UST work. LUNA is a crypto asset which has a fluctuating price and UST is a pegged asset that, in theory, should always be redeemable for $1 USD.
LUNA (the token) and UST (the stablecoin) are in a reflexive relationship (for one to go up the other must go down). It’s worth explaining this process at the outset.
“Mint” is a crypto term to create new tokens whilst “burn” is the term to “destroy” tokens.
It’s hard to wrap your head around how something that was created out of thin air can maintain its peg; let’s briefly look at situations when UST is > $1 and < $1 and how the peg is maintained.
UST Expansion: If demand causes the market price of UST >$1, arbitrageurs can burn $1 of LUNA to mint 1 UST, which can then be sold into the market for a higher price than the peg, netting a riskless profit. Market selling drives UST price back to its $1 peg, while minting expands UST supply. This process reduces the LUNA supply which is value-accretive to Luna holders.
UST Contraction: If demand causes the market price of UST <$1, arbitrageurs can buy UST at market and redeem it at par value (i.e., $1) for newly minted LUNA. Spot buying drives UST price back to its $1 peg, while redemptions contract the UST supply. This process increases the LUNA supply, which is value dilutive to LUNA holders.
$18 billion is the market cap of Coles… did investors really buy into the thesis of a stablecoin that is created out of thin air and gave it this value in less than two years? Don’t you need a utility for the token?
Enter Anchor. Anchor is a saving protocol built on Terra that guarantees a 20% yield on UST. You read that right – 20%. It is popularly known as the “Anchor yield” and even the “Anchor yield guarantee”.
A large portion of the UST user base is not holding UST speculatively but actively using it for savings. As long as market participants agree that 1 UST is redeemable for 1 USD, the faith is maintained, and a large portion of believers simply cannot pass on that juicy 20% “risk-free” yield.
This, in essence, is how UST and LUNA became so big – to the tune of $18 billion USD. People believed that the algorithmic stablecoin would maintain its peg and they would get a risk-free 20% yield.
What happens when the market loses faith that 1 UST is redeemable for 1 USD? Enter the “Death Spiral” which has plagued many algo-stablecoins.
Over the weekend, faith was shaken in the convertibility of 1 UST to 1 USD. The details are complicated but in simple terms; liquidity providers on Curve, the largest decentralised stablecoin exchange converted UST to other backed stablecoins en masse (to the tune of ~350 – 600 million USD). Due to such a large liquidity being withdrawn from the liquidity pools, the peg broke.
It is in effect a traditional bank-run as people started converting their UST to USD en masse but got lower and lower rates for it. As the faith got rattled more people started converting their UST for USD and LUNA entered into the death spiral as shown in the graphic above.
As at 11th May you could only get $30,000 real USD for $100,000 of UST, which in effect is the peg breaking – significantly – to 30 cents on the dollar.
Our research team did a deep dive on LUNA last quarter and concluded that it was not an ‘if’ but an inevitability that the peg would break. We concluded that 1 UST = 1 USD is purely based on the faith of the market and the incentive structures in place to get more participants were unsustainable. With no real assets backing UST and using predatory incentives such as offering a “20% Anchor yield” was simply unsustainable.
Our research team at DigitalX were sure that it was only a matter of time that the Death Spiral would play out – and when it would, it would be swift. The events over the past 3 days have proven our thesis.
DigitalX rejected LUNA as a viable investment in Q1 despite it fitting our Top 20 mandate.
The Luna Foundation Guard (“LFG”) was established in January 2022 with the core mandate of buttressing the stability of the UST peg. In order to achieve that, the non-profit added other assets such as Bitcoin (BTC) and Avalanche (AVAX) to its treasury with the intention to use them as a backstop in the event the UST peg broke.
As at 8th May, LFG had ~80,000 Bitcoin or US $3.2 billion in reserves to defend the peg. This indeed was a systemic risk to the market as investors worried what would selling billions of dollars of Bitcoin into thin liquidity and poor sentiment would mean to the price of Bitcoin.
Two days after, as at 10th May, US $3.2 billion worth of Bitcoin was exhausted in efforts to maintain the peg unsuccessfully. The price of Bitcoin suffered but positively, not as much as investors anticipated.
At the time of writing, we think that the systemic risks of LUNA and the UST depeg to the wider market is subdued. The majority of UST investors used the algorithmic stablecoin purely for savings within the Terra ecosystem and our analysis shows that the spillover to the wider decentralised finance (DeFi) ecosystem at this point is low. After the removal of Bitcoin from the LFG reserves we believe that the systemic risks to the wider market pertaining to LUNA and UST are low at this point.
DigitalX has identified several other algorithmic stablecoins that are at risk of suffering a similar death spiral. USDN (Neutrino USD) on the Waves platform is an example of one that has the potential to de-peg. It currently has a market cap of US$800 million.
Generally, all of the elements in DigitalX’s weighted value attribute matrix have a “red flag” category which can vastly influence our investment committee’s decision on whether we consider the asset for inclusion in our portfolio. During our analysis process we take considerable care in unpacking the tokenomics (token economics) of a project. As an example of what our committee would consider a “red flag” in this regard is the infinite supply of tokens in relation to the Cosmos (ATOM) project along with its maximum inflation rate of 20%. A question any investor must ask is – who is the marginal buyer of an asset that has an infinite supply? That is an example of a clear red flag for us.