A week of Terra: behind the collapse of a $26b stablecoin

In his communications with them, Kwon also said another outcome was that Bitcoin-backed algorithmic stablecoins could be liquidated and take everything with them “into a catastrophic failure that will take a long time, if ever, to recover from.”

To prepare for this type of liquidation event, Kwon and Luna’s team had started buying bitcoin in February in an effort to build up cash. Like a central bank, it would accumulate foreign currency reserves to back up its own currency in the event of a collapse.

Kwon had planned to bank $10 billion worth of bitcoins to defend the UST when needed, but he only reached a third of his goal. Trust in UST, which at $26 billion was the third-most-used stablecoin, was essential — not just for Kwon’s reputation, but for the thousands of wallets that used UST to represent US$1 on the books.

When the panic started, Kwon started selling bitcoin and buying UST. It wasn’t enough. On Tuesday this week, someone – or certain organizations – had engaged in another dramatic dumping of US$650 million on all major exchanges.

The number of USTs for sale suddenly turned the markets around. If it was, indeed, coordinated, it had all the hallmarks of George Soros’ famous raid on the peg, which brought him millions and cemented his legacy as a fearless trader.

But this time it wasn’t Britain’s Chancellor of the Exchequer throwing money at a wall. It was Kwon. He sold his billions of bitcoins to match the sale and support the price of UST. But these transactions were driving down the price of bitcoin and depleting its reserves. The game was over. The dreaded death spiral was in motion and would be nearly unstoppable.

Terra was now in the headlines, dominating the airwaves and serving as a clarion call for the legion of crypto naysayers who predicted its demise.

On Wednesday (AEST), the UST was in freefall and its peg had decoupled from the US dollar so drastically that US Treasury Secretary Janet Yellen referred to the UST by name as she asked new to Congress to pass legislation regulating stablecoins.

“I think it just illustrates that this is a rapidly growing product and there are some rapidly growing risks,” she said.

Kwon, who had been fairly quiet on Twitter, emerged on Wednesday evening to outline a plan to stabilize his seriously unstable stablecoin. But the collapse had left a huge amount of uncertainty and mistrust in the markets.

On Friday, UST was buying just US8¢ on the dollar, wiping out nearly $18 billion of value that depended on this asset to provide a stable unit of US$1. In the afternoon, the Luna blockchain was frozen, meaning all coin transactions were halted.

Rise of the Fools

While most stablecoins are backed by real US dollar assets, UST used financial engineering involving a sister currency called Luna to maintain its peg. The project evangelists dubbed themselves Lunatics and poured their hearts, souls and money into the project.

The idea was that if the UST price fell below $1, traders could “burn” the coin – or permanently remove it from circulation – in exchange for US$1 worth of new units of its sister cryptocurrency called Luna. . This would reduce the supply of UST and increase its price.

Conversely, if the UST climbs above US$1, traders could burn Luna and create a new UST. This increases the supply of stablecoins and lowers its price towards US$1. The idea was to encourage the market to always find the arbitrage opportunity between the UST/Luna couple.

Despite the tiny gains traders could make from all that burning and minting, it wasn’t really enough to entice them to stick around for the long haul. So, Kwon and his Luna Foundation Guard team decided to pay them off.

A widely used feature of many DeFi and crypto protocols is to offer participants a healthy “yield,” or some type of interest rate, to reward them for their activities. And those returns can be quite generous.

In the case of Terra, the thousands of traders who maintained the US$1 peg were charged an 18% “interest rate” for their burn and mint activity. This performance was paid in UST by the Luna Foundation Guard. And if one UST could be traded for US$1, then that was a very good return on the US dollar.

It is this model that underpins TerraUSD which, since its launch in 2018, has exploded to become the third most widely used stablecoin in the world, attracting over $18 billion worth of crypto into the system.

The profile was being built. In February, Terra signed a $40 million sponsorship deal with the Washington Nationals, the baseball team of which former US Federal Reserve chief Ben Bernanke was a big fan.

US Treasury Secretary Janet Yellen.

Faithfully, Terra was hovering around its US$1 peg, and those who participated in the minting and burning earned a terrific return on their money. And because it wasn’t backed by US dollars or US paper, it could boast that it wasn’t beholden to those pesky regulators that can spoil the fun of the free market.

In the case of UST, investors could also sign up for a program where they could earn a return of up to 20% by lending their coins – at one of the highest rates in the market.

The strategy of subsidizing users to participate isn’t too different from the Silicon Valley mantra of ubiquity first, profits second, in which startups raise so much money the fastest. possible to grow as much as possible to reach a sustainable scale.

Some have called this activity a Ponzi scheme. While crypto enthusiasts prefer the term “incentive mechanization scheme,” the process of attracting new investors with payouts from old ones is indisputable.

One River Digital’s Head of Quantitative Assets Paul Ebner describes the process as “escape gear”. If Terra’s de facto treasury (the Luna Foundation Guard) could pay those returns long enough to grow, it could diversify into a larger pool of assets.

“The network didn’t have enough push to enter Bitcoin’s digital orbit,” he said in a note to clients. “The attempt was not in vain, it was risky. The 20% return on a UST deposit was commensurate with risk.

But, after a week in which the third-most-used stablecoin crashed, investors of all stripes are reassessing how well they understand the mechanics that power these highly-rated, but often untested assets.

Along with the billions wiped from the books of American investors, Kwon’s fortunes also dwindled. But, luckily for him, it seems he was never motivated by money.

“We don’t intend to come out of this journey being billionaires,” he said. The generalist in November.

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