Recent tightening of monetary policy has led to sharp falls in many financial markets, including cryptocurrencies that lost nearly $ 1 trillion in market capitalization in just one week. Extreme market volatility has led to the disintegration of the Earth ecosystem. TerraUSD (UST), a stable currency linked to the dollar, and its sister token LUNA plummeted and withdrew from the quota, causing billions in losses to investors and accelerating the ruin of other cryptocurrencies. This debacle has disproved the high claims of an innovative crypto-financial ecosystem supposedly immune to traditional banking (TradeFi). The Stablecoins, a race of cryptocurrencies promoted for their supposed stability, became vulnerable during the week ending May 13, 2022, showing a vision of how things can go terribly wrong. The algorithmic stable currency UST lost its dollar value, collapsed and eliminated almost $ 50 billion in market value. The collapse of the Earth ecosystem raises urgent questions about the robustness of new cryptographic assets and the surrounding regulatory framework.
What are Stablecoins?
Stable currencies are digital currencies linked to a benchmark to provide stable prices and purchasing power. These currencies serve as a medium of exchange in the liquidity exchanges of Crypto Exchanges and Decentralized Finance (DeFi). Most pending stablecoins circulate in public blockchains, such as Ethereum, Binance, Polygon, etc., and are pegged to the U.S. dollar. However, they can also be linked to other fiat currencies, baskets of coins, other cryptocurrencies, or commodities such as gold.
Stablecoins custody they require trust in a third party and are issued by intermediaries, who act as custodians of the reserve assets. These intermediaries offer the 1 by 1 rescue of stablecoins for US dollars or other fiat currencies. The major stable currencies pegged to the US dollar are Tether (USDT), Binance (BUSD), Circle (USDC) and TrueUSD (TUSD). These stable currencies pegged to the US dollar are too collateralized, and the peg is defended by US dollar asset reserves, i.e. bank deposits, Treasury bills, commercial paper, and so on.
Stable coins without custody replace trust with innovative economic mechanisms. These stable currencies are backed by overcollateralised cryptocurrencies and / or smart contracts. Deposited fiduciary assets are never held with an intermediary or third party. Fiat pegs for unguarded stable coins are defended by two mechanisms. Guarantee mechanisms use cryptocurrency reserves to hold the peg. Algorithmic mechanisms use financial engineering to defend the peg by buying or selling stablecoin against an associated government cryptographic token. Examples of algorithmic stable currencies without custody include terraUSD (UST), Magic Internet Money (MIM), frax (FRAX), and neutrino-usd (USDN). MakerDAO’s (DAI) is an example of a stable overcollateralized currency without custody.
Why are Stablecoins so popular?
Investors prefer to buy cryptocurrencies such as bitcoins, ether and more, using stable fiat-linked currencies to maintain a stable price and purchasing power. Stablecoin deposits offer higher returns than those available in fiduciary deposits, making them an attractive class of revenue-generating assets. In addition, stablecoins are cryptographically secure, allowing for peer-to-peer financial transactions that are settled almost instantly and allow markets 24 hours a day / 7 days a week / 365 days a year.
Earth’s economy consisted mainly of two groups of tokens: one for the UST stablecoin and the other for LUNA. The UST dollar bond was maintained by buying or selling UST against LUNA. If UST rose above the peg, the protocol encouraged and expected traders to coin UST as needed and burn LUNA until UST dropped to $ 1; the increase in UST’s supply would put downward pressure on its price. If UST fell below the peg, the protocol was encouraging and hoped traders would do the opposite; continuously burns UST and mint MOON until UST rises to $ 1; the decline in UST’s supply would put upward pressure on its price.
UST can also be traded with other stable currencies in various cryptocurrencies exchanges and Defi liquidity groups, contributing to the stability of the dollar.
The Achilles heel of the Earth ecosystem was the Anchor Protocol: a sister platform to savings, borrowing and borrowing that promised a 20% annual percentage return (APY) only on UST bets / deposits and not on other stable currencies like the Tether USDT , Circle USDC, or Maker DAI. Anchor’s attractive performance exclusively at UST has created frantic demand, leading to a dazzling expansion in the number of USTs in circulation. Wrapped up as a dollar-like asset, UST was primarily bought and deposited in Anchor for a 20% return. In November 2021, UST’s market capitalization was just $ 2.27 billion, peaking at $ 18 billion in May 2022. During the same time, LUNA also doubled in price. Anchor was home to $ 14 billion, 75% of all UST’s $ 18 billion current supply.
Anchor’s 20% APY Lure – Making Of A Ponzi Scheme?
Cryptographic protocols that offer high returns on deposits generate revenue by lending more deposited assets and paying investors a portion of the interest earned. However, the Anchor protocol is unlikely to generate enough revenue to pay for its promised 20% APY payments. Anchor loans have only received an annual percentage rate (APR) of 10% of their extended loans. Anchor has potentially generated additional revenue in securing the borrower’s down payment, which may have helped to mitigate its payment obligations. Anchor also encouraged borrowers by paying them 7% APY in the governance anchor token (ANC) of the native Anchor Protocol to borrow UST, reducing their net flows.
Anchor’s relationship with UST could be judged as an ingenious mechanism for fabricating the demand for a stable currency or a veiled Ponzi scheme to attract money seeking returns. Even with a succulent 20% APY wrap in an asset traded as a proxy for the U.S. dollar, UST has even been able to attract investors that typically avoid volatile cryptocurrencies markets.
In February 2022, Do Kwon, the founder of Terraform Labs (link) and Terra Face, added $ 450 million to the reserves, raising concerns from outsiders. Since early 2022, Do Kwon has also been buying Bitcoins to bolster reserves.
The outflow of 20% of the UST deposit / deposit was probably higher than the inflow obtained from UST loans, creating a systemic outflow and a reserve deficit.
Earth Collapse: Market Volatility, UST Size, Anchor APY Lure, and Algorithmic Plug
The collapse of the Earth ecosystem has been catalyzed by extreme volatility, the destabilization of cryptographic markets, the rupture of the UST peg, and a series of major withdrawals from Anchor. Along with large withdrawals, UST was also sold to trade other stable currencies (backed by traditional assets) through various DeFi liquidity groups.
When UST started to lose its peg and traders wanted to get out of UST, they had two options.
1) Exchange the UST-LUNA mint burning algorithm within the Earth ecosystem.
2) Exchange the discounted UST with alternative stable currencies (USDC, BUSD, ..etc.) In DeFi deep liquidity funds.
When the UST fell slightly below $ 0.02 during the week of May 9, 2022, traders began exchanging UST for any other stable currency, namely Tether’s USDT or Circle’s USDC. Eventually, the specific liquidity fund that allowed these operations was unbalanced; it now had much more UST than other stable currencies. To correct the course, the group began offering UST at a discount in hopes of getting the arbitrators to make the opposite change to rebalance the group, which was not happening. As selling pressure on UST continued to rise, it lost its $ 1.00 fix and began to fall out of control. When traders were unwilling to buy them, both UST and LUNA went into a death spiral, confidence in the terrestrial ecosystem plummeted and UST’s liquidity in DeFi pools dried up. Once UST lost the stable currencies of the counterparty for trading, it lost the pricing mechanism, causing a market failure. Both UST and LUNA were removed from all bags. Ironically, before the bearish run, UST was the third most stable currency by total market capitalization, just behind Tether and USD Coin.
The shocking crash of the Earth ecosystem, along with its stable UST currency and sister token LUNA, has led to the stable algorithmic failure of the billion-dollar currency market. The consequence of Terra LUNA / UST was a wake-up call for everyone to recognize the risks inherent in each stable currency and, in some, much more than others. These events also raise questions about the robustness and long-term viability of algorithmically stable currencies. Many fear that a one-to-one point gap in US dollar-backed stable currencies could lead to cross-margin sales in other asset classes and have serious repercussions on traditional financial markets and the cryptocurrency. Following this bloodbath, to reduce the hidden systemic risks of stable currency markets, regulators may decide to incorporate stable currencies into the scope of electronic payment regulations. Michel Triana, CEO of MeanFi, says: “The USD-backed digital currency of the Central Bank (CBDC) cannot get to the cryptocurrency fast enough. “To the US Federal Reserve. To all those who preach” a decentralized world needs a decentralized currency, “I say, yes, that’s what Bitcoin is.”
Stable cryptographic assets are a much needed building block to unite TradFi and DeFi. Stable currencies are a new class of innovative financial assets in their childhood that have the potential to revolutionize finance and find adoption far beyond their current use in cryptocurrency markets. Like many technological innovations that experienced setbacks in the early stages before takeoff, it may be too premature to write an obituary for this class of cryptographic assets.