As you may have noticed, things in the market have been volatile lately.
Yesterday’s lunacy, pun fully intended, was driven by idiosyncratic factors, but there was also secular risk from Terra’s model that bears had noted for months. Much of this was influenced by Luna’s well known mint-and-burn mechanic.
As the circulating supply of UST grows, it puts upward pressure on the price of LUNA. This works extremely well in bullish markets, as it allows users holding LUNA to see direct value creation for their tokens as the underlying stablecoin use-cases grow and evolve. However, in a risk-off market, the same mechanisms can create problematic cycles for trying to reclaim a lost peg.
Let’s quickly run through exactly what happened yesterday with LUNA and UST, and think about exactly what the Terraform Labs (TFL) team needs to do to ensure such a bank run won’t occur again.
- Flight to Risk-off assets. Macro conditions have obviously been worsening for a while. Unaccommodating rate and inflation environments globally have put sustained pressure on equity and crypto yields. This has caused investors to shift out of undercollateralized stables (UST) in favor of fully cash / cash equivalent collateralized stables (USDC, USDT).
- Underlying Asset / Liability mismatch for UST. Although not collateralized, the fact that UST can always be redeemed 1:1 for $1 of LUNA creates a direct relationship between token demands. In up markets, the mismatch isn’t an issue. However, in down-markets, concerns about balance sheets become more tangible, and algorithmic risk falls strongly out of favor.
What Went Down
- Terraform announces, and executes, a plan to move $150mn of UST liquidity out of the 3CRV + UST pool in preparation for the launch of the 4pool. Simultaneously, an anonymous address with fresh funds bridged and dumped $85mn of UST.
- This sale caused the Curve pool to become imbalanced, and put downward pressure on UST price. To help correct for this imbalance, TFL removed another $100mn of UST liquidity from Curve.
- This transfer was insufficient to correct ongoing redemptions, which were driven by both the unexpected move downward and the ongoing flight to risk-off assets.
- Protocol design intentionally always allows for UST to be redeemed for $1 of LUNA, which can then be sold. This allows the price / demand of LUNA to help defend the peg of UST. However, in the case of a large bank run, LUNA price can contract rapidly. This means that subsequent UST redemptions have to be exchanged for increasingly large amounts of LUNA, creating a potential death spiral. It also has the side effect of causing network congestion, as investors pay high gas fees in an attempt to get UST exchanged.
- This congestion caused Terra’s chain activities to be suspended across a handful of platforms and chains, further adding to panic.
- Positions in Anchor are largely collateralized by LUNA. As the price of LUNA dropped from redemption pressure, walls of UST were arriving on the market to be purchased by liquidators. This further puts pressure on the UST price across chains.
- TFL partners add $280mn+ non-UST liquidity to the 3CRV + UST Curve Pool in an attempt to staunch bleeding. This liquidity is quickly consumed, as outflows are significantly higher than the ‘bailout’.
- Anchor total UST deposits fell from ~14.1bn UST on Friday, May 6th, to 11.7bn UST on Sunday, May 8, 2022. This accelerated down to sub 10bn UST on 5/9 in the morning, with deposits falling 1bn UST within a few hours. Deposits are sitting at ~6bn UST in Anchor – down over 50% from all-time highs.
- This was likely partially aggravated by looped UST deposits in the Degenbox, which allows for leveraging UST yield generation via Anchor.
- These UST removed are either:
- Trying to be redeemed for LUNA at $1, putting sustained downward price pressure on LUNA.
- Being transferred off Terra chain, and sold for a discount, causing downward price pressure on peg.
- Drop in peg price of UST accelerates the size of the loss LUNA takes on each redemption, as they’re effectively paying $1 for less.
- Money is removed from the TFL Bitcoin Wallet per a decision by the ‘Luna Foundation Guard’ (questionably decentralized), composed of people on the LUNA core team. They:
- Loan $750M worth of BTC to OTC trading firms to help protect the UST peg.
- Loan 750M UST to accumulate BTC as market conditions normalize.
- The problem is that UST is trading extremely cheap, so TFL’s ability to pay back Market Makers for their peg support decreases rapidly. If BTC was sold (hard to show, definitively, but likely), it would put downward pressure on the price of BTC, which would further drag down the entire market, and aggravate the spiral.
As of afternoon on 1/22, Peg has recovered from a low of $0.66 to $0.90. Despite this, LUNA price has steadily decreased as redemptions of UST into LUNA continue to be market sold.
Many ‘Lunatics’ will likely remain bullish, citing UST’s ability to withstand a bank run, and the idiosyncratic nature of the initial attack on the Curve Pool. However, there are a few main bear counterarguments that remain important, and solving them is crucial to Terra’s future success.
The key point on the Terra bear thesis remains the lack of non-mercenary yield (read: Anchor) protocols for interacting with UST. Stablecoins are meant to be highly liquid vehicles for transacting. However, for UST, liquidity was leveraged and highly concentrated in a single platform. Anchor had $14bn in deposits a week ago, compared with an $18bn Market Cap for UST. Clearly, the number of actual use cases beyond depositing to earn in Anchor (or derivatives of Anchor – like Degenbox) are limited.
That makes UST a risk-on asset, relative to other stables like USDC and USDT, which are cash or cash equivalent backed. Yields generated by UST remain largely subsidized, with Anchor yields compressing. As investors shifted from being risk-on and hunting yield, to risk-off and becoming yield agnostic, UST’s sole appeal became less relevant. Even prior to the Curve pool issues, money had begun flowing out of Anchor.
So, what’s the solution for Terra?
- First, the team has to once again establish confidence in the algorithm and the model as a whole. Without it, the underlying ‘algorithm’ won’t work. Sell pressure on LUNA will simply be sustained until there is insufficient capital to defend the peg. Speaking of, there’s a lot of debate around fundraising for peg defense, which should indeed help with some of this fear. That said, it’s hard to say that this process won’t play out again, unless…
- Second, and most important, is creating use cases for UST outside of Anchor. While this has been an ongoing goal of the Terra ecosystem for a while, it has yet to come to fruition. If UST is being held through treasuries, used in pools, and otherwise genuinely integrated into DeFi, bank runs become much more difficult.
This report is not investment or trading advice. Please conduct your own research before making any investment decisions. Past performance of an asset is not indicative of future results. The Author may be holding the cryptocurrencies or using the strategies mentioned in this report.