VegaX Flash News Report: Bank Run on Terra’s UST— May 2022
The digital asset community suffered through one of the bloodiest Mondays in recent memory. Confusion, calamity, and capitulation characterized the market events, leaving investors at the mercy of plummeting portfolio values, margin calls, and liquidated positions.
Though the dust has somewhat settled, it is not immediately clear what exactly happened, but this Flash News installment will provide an approximation of the events that led up to — and may have caused — Terra’s UST stablecoin to lose its peg and ultimately fall to a low of $0.2998 on 05/11.
Setting the Scene
Before getting into the details of what transpired leading up to and during the de-peg event, some context of the Terra Ecosystem and stablecoins, generally. As well, it is important to understand that other stablecoin products, such as USDC and USDT are directly collateralized by USD held in bank accounts. This makes those products inherently “centralized” in that one organization is in charge of maintaining the peg.
Terra’s flagship products are a multi-currency group of algorithmically pegged stablecoins, chief among those being UST. All of these stable coins are pegged directly to the local currency they emulate; i.e. UST is pegged to the United States dollar.
Supporting those stablecoins is the LUNA token, which is meant to hold the value of the ecosystem and act as a volatility cushion, so to speak. In very simple terms, whenever LUNA is redeemed for an equivalent value of UST, that LUNA is then burned; this is meant to decrease supply and increase the price of LUNA.
The Terraform Labs team has further built in algorithmic incentives to traders in order to maintain this peg — the mechanism allows UST to be redeemed for $1 of LUNA, even if the value of UST<$1. Remember this, it will be important later.
In addition to this mechanism, an organization established to oversee the stability of the Terra Ecosystem — the Luna Foundation Guard (LFG)— had expanded the assets held in their reserve accounts to include Bitcoin (BTC). Co-founder of Terraform Labs, Do Kwon, ardently boasted that the LFG’s goal was to accumulate ~$3billion in BTC as a further backstop against UST losing its peg.
What happens when the music stops?
The first sign of trouble occurred on Sunday evening 05/08 (CST) when a sizable amount of UST was swapped for USDC on Curve, the world’s largest stablecoin liquidity pool protocol. This first attack was successfully defended by a covering swap of ETH <> UST to replace the lost liquidity.
Considering the state of the digital asset market (and the broader macroeconomic outlook), investors were understandably nervous about the initial de-pegging event — but this sentiment was quickly swept away. However, this ease in concern would prove to be unwarranted; the battle had yet to be won.
Slowly throughout the morning of Monday 05/09, more and more UST flooded the spot market. A seemingly endless amount, in fact. So much so that at 1:34 pm CST, the LFG reserve wallet was emptied of its entire bitcoin cache — 42,530.82 BTC (USD 1,307,701,285.72) — which was sent to Binance to be sold/swapped for UST, in order to defend the peg.
At 3:34 pm CST, the LFG reserve wallet received an additional 28,205.54 BTC (USD 881,080,227.58) which was then subsequently sold at 8:20 pm CST, again, to defend the peg. Unfortunately for Terraform Labs and LFG, by this point, the ‘Bank Run’ on UST was in full swing: any investor who could be converting their UST into another stablecoin, OR redeeming it for LUNA at a discount — recall earlier, UST can be redeemed for $1 of LUNA even if UST <$1.
This led to a massive increase in available LUNA supply, further devaluing the asset. Add to this the steady price decline of BTC over the past week, and you’ve got a recipe for the perfect storm. The community is reeling: confidence in Terra is shot, LUNA is trading under $10 and UST has yet to reclaim its peg.
Was this event a result of several coincidences coalescing around one blockchain ecosystem by chance, or was this a calculated and coordinated attack carried out by ultra-sophisticated players?
Who Profits? Follow the Money
At this point, we will depart from objectively reporting on the events that transpired and explore speculations about who might have been responsible for the attack, and what the downstream effects of the de-pegging event could be.
Twitter has been abuzz, and many are insinuating that multinational Hedge Fund giant Citadel was at the forefront of the attack. Though, frankly, it’s not of the utmost importance who the perpetrator is exactly, more important is ascertaining if this was a planned attack. The daily newsletter on milkroad.com provides a great play-by-play:
- The “attacker” cleared out liquidity pools on Curve Finance, which was ~$300M UST.
- Then they started dumping the UST which caused people to panic and sell their UST — this all caused a minor de-peg.
- UST backers like Jump and LFG started selling other crypto-assets like ETH and BTC to buy UST and bring the peg back.
- That may have been exactly what the attacker wanted because it seems like they were actually shorting BTC (aka betting the price was going to go down, they anticipated this because they knew LFG would need to sell their BTC to regain peg).
- Basically — they knew the counterpunch and were going to profit from that too.
- Mass panic hits and people start selling on exchanges which caused huge congestion.
- Exchanges halted UST and Luna trade until things could stabilize.
- This caused even more panic so people started withdrawing even more UST from Anchor, which caused a bank run for the protocol.
- Over 50% of all funds were withdrawn in the span of 48 hours.
There were many critics of Terraform Labs’ algorithmic stablecoin project, a common concern shared was that if the demand for UST wasn’t extraordinarily high that the peg was at risk of a bank run (i.e. during uncertain market conditions OR when the price of LUNA drops sharply).
Putting the identity of the perpetrators aside, this was an extremely lucrative operation — and given broader macroeconomic uncertainties, all the perpetrators needed was to bide their time and wait for the right entry.
Remember that before 05/09, LFG’s main reserve asset (aside from LUNA) was BTC, recall as well that the price of BTC had been steadily declining for ~5 days, meaning that the notional value of LFG’s reserve was declining as well.
If Citadel had acquired ~100k BTC via loans, OTC deals, or a combination of both, AND, was able to acquire a sizable amount of UST as well, Citadel would then be in a perfect position to steadily bleed down BTC price via consistent sell pressure. From there, they could open up a short position on BTC and/or LUNA, attack the available liquidity in Curve’s 3pool and finally flood spot markets with UST. This would further remove UST from its peg and likely cause LFG to sell their reserve BTC to an already soft market — continuing the downward trend and thus, creating a massively profitable short position on BTC (and/or LUNA).
Speculation and Musings
This next section is purely speculation, but there are tea leaves to be read.
It is no secret that the United States Government has its eye on the digital assets markets — President Biden was clear in his executive order some months ago that he wants to institute some sort of regulations in order to protect retail investors.
Along those lines, two recent news stories are quite interesting:
The first is the Federal Reserve’s 5/09 Financial Stability Report, which repeatedly points to the de-pegging risk associated with stablecoins. Curious timing on the surface, but to be fair, the November 2021 report outlined many of the same concerns covered in this week’s issue.
The second was the statement given by US Treasury Secretary Janet Yellen at this (05/10) morning’s Senate Banking Committee meeting. Notably, the former chair of the Federal Reserve stated that “I think that simply illustrates that this is a rapidly growing product and that there are risks to financial stability, and we need a framework that’s appropriate,” she said. She later said legislation to address crypto regulation would be “appropriate” this year.
US regulators have been chomping at the bit to reign in the growth of the digital asset markets, and what could be a better reason for intervening (interfering?) than a perfectly-timed stable coinde-pegging event?
At this point, it is hard to know for certain who might have had a hand in this, and speculation is useful only to a point, but as Winston Churchill once said:
“Never let a good crisis go to waste.”
As the days pass, and the fog of battle subsides, hopefully, more information becomes available as to the exact goings-on of the UST de-pegging event.
It seems that critics were on the right path in this case: algorithmically pegged stablecoins carry massive tail-risk, especially when since market conditions are not favorable.
As opposed to direct collateralization (USDC and USDT) the Terraform Labs and LFG teams were *essentially* banking on the value of two assets to hold up: LUNA and BTC. When market confidence in BTC began to waiver, LFG’s already undercollateralized reserves ($1.3b BTC vs $18b market capitalization for UST) became worth even less, and defending the peg with reserve assets became impossible.
In hindsight, holding a reserve asset that is highly correlated with the product that such a reserve is meant to defend seems like a losing proposition. If a project wanted to circumvent the need to hold an equivalent amount of USD, they could hold something like gold, but then there are issues of illiquidity and cumbersome custody processes. Many questions, very few concrete answers at the moment.
For now, we at VegaX will continue to build safe and accessible investment products, and provide our clients with as much high-quality educational content as possible. Thank you for reading; stay safe, and be kind — this too shall pass.
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