DigitalX: Why We’ve Flagged Luna Red and How We’re Avoiding More Death Spirals
An $18 billion algorithmic stablecoin loses its peg – a story of how Terra Luna and its stablecoin, UST, came crashing down
How is this size even possible? After all, $18 billion is more than Coles’ market capitalization! And it took Coles 108 years of hard work, blood, sweat and tears to achieve this value. How did this algorithmic stablecoin, UST, achieve this in less than two years?
DigitalX’s research team recognized the risks to the Terra Luna ecosystem and its algorithmic stablecoin, UST, early on and dismissed it as a viable investment in the first quarter of 2022 – although it fits our mandate of the Top 20.
DigitalX is a safe pair of hands for those looking to participate in this emerging crypto asset class – whether as exposure to Bitcoin or through our actively managed fund capturing the growth of the emerging Web3 sector.
What is Terra Luna (LUNA), UST and who is behind it?
The easiest way to understand Terra is to think of it as a traditional bank that facilitates payments, transfers, investments, loans and savings, but with one key difference: this bank does it all in its own currency. ; not USD or AUD, but its own algorithmic stablecoin, UST, (called TerraUSD). We will talk more about what UST is below.
Terra was founded in January 2018 by Daniel Shin and Do Kwon. Do believes that a decentralized world needs a native decentralized currency and is on a mission to replace centralized stablecoins like USDT, USDC. Terra’s goal is to make UST the de facto stablecoin used in the crypto universe and even in traditional e-commerce.
What is an algorithmic stablecoin?
Algorithmic stablecoins use algorithmically controlled market incentives to maintain a stable price against a currency such as the US dollar rather than supporting the price with assets such as real USD in the bank account or goods of treasure.
There are several types of algorithmic stablecoins on the market – some are partially backed by real assets and some are created literally from scratch. Needless to say, these are fascinating experiments in financial engineering.
How does an algorithmic stablecoin work?
But how does it work? You can’t just create a coin from scratch and claim it has the same value as a real USD – how is parity maintained?
This is where we come into how LUNA and UST work. LUNA is a crypto asset that fluctuates in price and UST is an indexed 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 is worth explaining this process at the outset.
- To hit 1 UST, $1 of LUNA must be burned
- To redeem 1 UST, $1 worth of LUNA must be minted
- In summary: each UST created burns $1 of LUNA, and each UST destroyed generates $1 of LUNA
- This is how the UST maintains the anchor
“Mint” is a crypto term for creating new tokens while “burn” is the term for “destroying” tokens.
It is difficult to understand how something that has been created out of nothing can hold its ground; Let’s briefly look at situations where UST is >$1 and
UST extension: If demand causes the market price of UST > $1, arbitrageurs can burn $1 worth of LUNA to strike 1 UST, which can then be sold into the market at a higher price than the peg, achieving a profit without risk. The market sell brings the UST price back to its $1 anchor, while the mint increases the UST bid. This process reduces the supply of LUNA which creates value for Luna holders.
Contraction UST: If demand causes the market price of UST to fall below $1, arbitrageurs can buy UST at the market and buy it back at face value (i.e. $1) against a new LUNA. Buying spot brings the price of UST back to its $1 anchor, while buybacks contract the supply of UST. This process increases the supply of LUNA, which has a dilutive effect on LUNA holders.
But wait… how did UST get so big?
$18 billion is the market capitalization of Coles… have investors really bought into the thesis of a stablecoin created from scratch and given it that value in less than two years? Don’t you need a utility for the token?
Walk in Anchor. Anchor is an economy protocol built on Terra that guarantees a 20% return on UST. You read that right: 20%. It is popularly known as “anchor yield” and even “anchor yield guarantee”.
A large portion of the UST user base does not hold UST speculatively but actively uses it to save. As long as market participants agree that 1 UST is exchangeable for 1 USD, faith is maintained and a large portion of believers simply cannot pass on that juicy 20% return “risk free”.
That’s basically how UST and LUNA became so big – to the tune of US$18 billion. People thought that the algorithmic stablecoin would maintain its peg and earn a risk-free return of 20%.
What happened over the weekend and why did the stablecoin peg snap?
What happens when the market loses confidence that 1 UST is exchangeable for 1 USD? Enter the “death spiral” that 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 decentralized stablecoin exchange, have been mass converting USTs into other collateralized stablecoins (to the tune of around $350-600 million). Due to the withdrawal of such a large amount of liquidity from the liquidity pools, the anchor broke.
As a result, the “risk-free” return of 20% becomes very risky
This is actually traditional bank management, as people started converting their USTs to USD en masse, but got lower and lower rates. As the faith shook, more and more people started converting their UST to USD and LUNA entered the death spiral as shown in the chart above.
As of May 11, you could only get real $30,000 for $100,000 of UST, which is effectively breaking the peg – significantly – at 30 cents on the dollar.
How did DigitalX identify the risks that prevented Luna from being added to the portfolio?
Our research team did a deep dive on LUNA last quarter and concluded that it was not an “if” but an inevitability that the ankle would break. We concluded that 1 UST = 1 USD is purely based on market faith and that the incentive structures in place to attract more participants were unsustainable. Without real assets supporting the UST and the use of predatory incentives such as offering a “20% peg return” was simply unsustainable.
Our research team at DigitalX was convinced that it was only a matter of time for the death spiral to unfold – and when it did, it would be fast. The events of the past 3 days have proven our thesis.
DigitalX rejected LUNA as a viable investment in Q1 despite it fitting our Top 20 mandate.
How will the collapse of LUNA and UST depeg affect the broader market?
The Luna Foundation Guard (“LFG”) was established in January 2022 with the primary mandate of enhancing UST ankle stability. To achieve this, the non-profit organization has added other assets such as Bitcoin (BTC) and Avalanche (AVAX) to its treasury with the intention of using them as a safety net in case the UST peg breaks. .
As of May 8, LFG had approximately 80,000 Bitcoin or US$3.2 billion in reserves to defend the peg. This was indeed a systemic risk to the market as investors worried about what selling billions of dollars worth of Bitcoin in thin liquidity and bad sentiment would mean for the price of Bitcoin.
Two days later, like May 10, US$3.2 billion worth of Bitcoin was depleted in efforts to maintain the peg without success. Bitcoin price suffered but positively, not as much as investors expected.
At the time of writing, we believe that the systemic risks of LUNA and UST extended to the broader market are under control. The majority of UST investors have used the algorithmic stablecoin only to save within the Terra ecosystem and our analysis shows that the fallout to the broader decentralized finance (DeFi) ecosystem at this stage is small. Following the withdrawal of Bitcoin from LFG reserves, we believe systemic risks to the broader market regarding LUNA and UST are low at this stage.
What are other potential death spirals and how does DigitalX identify red flags?
DigitalX has identified several other algorithmic stablecoins that are at risk of suffering a similar death spiral. The USDN (Neutrino USD) on the Waves platform is an example of this that has the potential to unanchor. It currently has a market capitalization of US$800 million.
Generally, all items in DigitalX’s weighted value attribute matrix have a “red flag” category which can greatly influence our investment committee’s decision as to whether we consider the asset to be included in our wallet. During our analysis process, we take considerable care in unpacking the tokenomics (token economy) of a project. As an example of what our committee would consider a “red flag” in this regard is the infinite token supply in relation to Project Cosmos (ATOM) as well as its maximum inflation rate of 20% . A question every investor should ask is: who is the marginal buyer of an asset with infinite supply? This is an example of a clear red flag for us.
This article was developed in conjunction with DigitalX, a Stockhead advertiser at the time of publication.
This article does not constitute advice on financial products. You should consider obtaining independent advice before making any financial decisions.
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