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Summary of the thesis
Terras Luna (LUNA-USD) has lost over 99% of its value in just a few days. Additionally, USterra (UST-USD), Terra’s algorithmic stablecoin, is currently trading at just $0.12. Before the crash, UST was 10th largest crypto by market cap, so it’s not surprising that this has rocked the crypto market.
But what happened to LUNA and UST? Are All Algorithmic Coins Doomed? And what about other stablecoins like Tether (USDT-USD), USDCoin (USDC-USD) and Dai (DAI-USD)?
The recent crash has given us a lot to think about and some very interesting insights into crypto and stablecoins.
What happened to LUNA?
The demise of Luna and UST came as a surprise to most investors, myself included. In my last article about LUNA, I talked about the potential of LUNA and expressed my belief that the price will increase. While I was aware of the paucity of algorithmic coins, LUNA’s success seemed to indicate that there might be room for them in the crypto market. Obviously I was wrong. Algorithmic coins require demand levels that cannot be guaranteed, and they will always be affected by events like the one we saw last week.
In hindsight, there have been a few warning signs over the past few weeks that LUNA and UST were on the verge of collapse.
The key here is to answer the question why did people have UST in the first place? And the answer is “dollar equivalent” returns of up to 20%. Before the UST imploded, Anchor, Luna’s lending and borrowing protocol, held over 72% of the outstanding UST.
Initially, UST invested in Anker could yield up to 20%, but those rates slowly declined as more people came to lend UST than to borrow. Additionally, following the passage of Proposal 20 in March, each time Anchor’s reserves increased by 5%, interest rates were reduced.
Anchor Deposits (Anchor Log)
On May 6th there was approximately 14 billion UST in Anchor, but over the weekend it was down to 11.7 billion and at that point UST was still pegged to the dollar.
However, as the mass exit continued, problems began to arise due to the manner in which this exit took place. There are two ways to sell UST. Exchange for LUNA Burn and Mint mechanism or sell on the open market.
So, those selling UST for LUNA caused inflation of the supply of LUNA, which pressured the coin. This can be seen in the diagrams below.
Change in VAT (Terra)
Change in LUNA (Terra)
On May 8th, LUNA had a supply of 343 million. On May 12, it was 32.3 billion.
On the other hand, those selling UST on the open market caused the UST to be deferred. Initially, UST started trading at $0.98, which created an arbitrage opportunity. People started putting their UST into liquidity pools, mainly at Curve Finance, to make a profit. In general, a liquidity pool in curve financing, for example, treats UST the same as USDT. These pools are in fact mechanisms for maintaining balance between these stablecoins, but this eventually contributed to the downfall of UST.
Suddenly these liquidity pools had too much UST. To balance the pools, Curve Finance did what it always does and started offering UST at a discount to incentivize referees to do the opposite, i.e. sell other stablecoins to buy/unpool UST take. However, arbitrageurs did not take this trade. Maybe it’s because they’ve seen the LUNA price plummet. There were also other factors that contributed to how very large and “unusual” deals that took place ignited the conspiracy theories.
In any case, a death spiral eventually took place. If the price of LUNA decreases, more LUNA must be minted to exchange UST for $1 of LUNA. This in turn increases the supply, which lowers the price, and so on. Eventually, LUNA’s market cap fell below that of UST, meaning it was game over for the algorithmic stablecoin.
USDT, USDC and DAI
As USterra plummeted, other stablecoins caught the storm, although some appeared to benefit. The three major stablecoins USDT, USDC, and DAI “experienced” the UST crash in different ways. Let’s start with USDT:
USDT price (CoinMarketCap)
USDT Market Cap (CoinMarketCap)
Above we see the price and market cap of USDT. We can see that USDT was heavily depegged on May 12th. This also coincided with nearly $3 billion in withdrawals. And while the peg has been maintained, USDT has lost nearly $10 billion in market cap.
Not the case with USDC:
USDC Price (CoinMarketCap)
USDC Market Cap (CoinMarketCap)
USDC started trading at a premium for a while, and its market cap has exploded in the last week.
Finally we have DAI:
DAI Price (CoinMarketCap)
DAI Market Cap (CoinMarketCap)
DAI has experienced something in between. We see that the bracket is both above and below its target level. We also see that the market cap has dropped significantly but seems to be recovering in the past few days.
Not all stablecoins are created equal
The collapse of UST created a lot of uncertainty regarding stablecoins but also left an opening in the market.
USDT is still the largest stablecoin, now closely followed by USDC, but it’s clear that it’s perceived as “weaker” by investors. USDT and USDC are quite similar operationally in the sense that they are both backed by dollar-denominated assets. The only difference is the composition of these assets and those behind each stablecoin.
Both stablecoins came under criticism last year for not being “100% dollar backed.” In response, the USDC claims it is now only backed by USD and short-dated government bonds. Meanwhile, USDT freed its holdings and had many assets that are neither dollars nor US debt. A large chunk of their fortune is “commercial paper,” which can really mean anything. However, USDT’s CEO recently announced that commercial paper was reduced by 50% in favor of US Treasuries.
The other issue is that USDT is operated by iFinex, the Hong Kong-registered company that also owns crypto exchange BitFinex. Meanwhile, Circle, which operates USDC, is an American company based in Boston that recently received investments from Blackrock and Fidelity.
Meanwhile, DAI, which is much smaller than the other two, is powered by MakerDAO, a “peer-to-peer organization formed on the Ethereum network to enable people to lend and borrow using cryptocurrencies.” DAI is therefore decentralized and decisions are made democratically among the holders of the MKR token. DAI is backed by over-collateralised loans on its exchange. Most of these are denominated in ETH, but USDC, for example, also accounts for a large part of it. In general, this is enough to keep the bond alive, but during extreme events, as happened in March 2020, the MKR token can also be diluted to support the value of DAI.
Final Thoughts
All in all, the collapse of LUNA brought many issues to light, let’s summarize them here.
First of all, algorithmic coins are not viable at this point. They can only work with a minimum requirement that cannot be guaranteed.
Also, not all stablecoins are created equal. For example, the market prefers USDC over USDT. But are these stablecoins safe? I believe the fact that we have seen these coins maintain their bond even after these extreme situations is strong evidence of this. The fact that they are not 100% cash backed doesn’t worry me. That’s how banks and even central banks work, and I’ve discussed that in more detail here.
Finally, the issue of governance seems important here. USDT is controlled by a foreign company, while USDC is “American controlled,” which some investors seem to prefer. Meanwhile, DAI is a decentralized coin that seems fundamentally more attractive. However, since it’s backed by a mix of assets, it’s less clear how stable it is.
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