The fall of Terra USD (UST) and LUNA have been difficult for investors, with many suspecting that an attack was orchestrated similarly to the infamous one levied on the Bank of England by George Soros in the early ‘90s.
Stablecoins have become a foundational element of DeFi, so the fall of the largest decentralized algorithmic stablecoin raises a number of important questions; among them, what can the stablecoin community take away from the situation and what responsibilities do builders take on when developing risky, open-source financial products?
To better understand where the stablecoin community goes from here, let’s examine what we know about the collapse of UST.
What happened to UST?
At the tail end of the 1980s, the UK suffered a period of steep economic decline. Inflation was rising and showing no signs of slowing so with few options available, the nation joined the European Monetary System (EMS).
Nations that take part in the EMS must defend exchange rate pivots, keeping their currency within a specified window. Upon entering the EMS, many viewed the sterling pound to be overvalued. In order to avoid the exchange rate falling outside of the mandated EMS window, interest rates continued to climb in order to attract foreign investment and keep the dollar strong. George Soros – with a cohort of big financial players – saw this as unsustainable and bet against the pound. By “shorting” the currency, they were essentially selling it with the promise to buy it back later, expectedly at a lower price, in turn putting downward pressure on the currency.
The U.K. had two options to combat devaluation:
- Selling foreign exchange reserves
- Raising interest rates further, attracting additional external capital
The Bank of England chose the former option, selling their reserves which were quickly depleted. The U.K. was forced to exit the EMS and the sterling pound devalued by over 15 percent, in what is now known as “Black Wednesday”.
History repeats with UST
UST recently faced what has been widely speculated as a similar type of attack, leaving many trapped to watch a two-day hyperinflation saga that felt like a timelapse.
As an algorithmic stablecoin, the supply of UST tokens adjusts itself using arbitrage incentives to maintain a $1 peg. Users control the net outflow by minting (issuing) and burning (redeeming) stablecoins, which will be explained below.
Protocols utilizing algorithmic stablecoins often garner the highest returns for lenders and liquidity providers. This yield then incentivizes users to continue minting and using the stablecoin. UST in particular offered a nearly 20% yield through its Anchor Protocol, notably higher than other decentralized protocols.
They come attached with greater risk than collateralized alternatives, as the model is great in theory but new in practice, and their price relies on narrative and market activity rather than intrinsic value given the lack of stable collateral.
These risks came into full view with the collapse of UST. Much like the Bank of England, it was left exposed – and someone exploited it.
The LUNA Terra network features two separate, but symbiotic, tokens: UST, an algorithmic stablecoin, and LUNA, which is used in governance and for minting UST.
To mint UST, users deposit LUNA into the network for a 1:1 value in stablecoins. The same works in reverse: when UST’s traded for LUNA, the network mints an equal value in LUNA, and the UST gets burned. To mint either token, an equal value of the other must be burned. This process can be seen visually below:
To incentivize liquidity providers to support the network, Anchor protocol enabled users to hold the UST in Anchor for a whopping 19.5% APY.
One UST can always be redeemed for $1 in LUNA, which created opportunities for profit whenever UST dropped above or below $1. Traders would profit, and the network continues to grow as users purchase UST, decreasing the total supply of LUNA and in turn increasing its price further. These lending incentives paired with consistent arbitrage opportunities were meant to sustain an organic, market-driven peg to the US Dollar.
And as it goes, the system was running quite well… right up until it wasn’t.
The collapse began Saturday, May 7th. A 3rd party, withdrew over $2 billion in UST from the Anchor protocol and sold hundreds of millions on the open market, in what has widely been considered a targeted attack on the network.
The supply shock pushed UST’s price down to around 90 cents, and considering that this was a time when both the traditional markets and blockchain markets were looking grim – investors subsequently fled in droves. More UST flooded a market already short on liquidity, and what followed was a cataclysmic descent.
As one UST can always be redeemed for $1 in LUNA, trillions of new LUNA were minted and sold in an attempt to regain UST’s dollar peg, diluting the price of LUNA to near zero through hyperinflation.
Before the attack, there were around 343 million LUNA in existence. Two days later that number had hyperinflated to just under 7 trillion.
Anatomy of a peg attack
Unfortunately, the possibility of this sort of attack happening on algorithmic stablecoins like UST has been widely acknowledged by leaders in the stablecoin community.
“The potential for these types of attacks is part of the reason we decided to issue Stably USD as a fully-collateralized stablecoin rather than an algorithmic token,” says Stably CEO Kory Hoang.
Published in 2018, Colton Robtoy’s Stablecoins vs. $T ‘Peg-Attacks’ by a Bank explains how different types of stablecoins would handle an attack on their peg.
Fully algorithmic stablecoins leave the system open to market manipulation and currency attacks. Investors would be quick to exit as the value of both assets is linked, potentially collapsing the network entirely.
Like the infamous George Soros assault on the pound, UST was shorted en masse. Without enough collateral backing it, there was nothing to absorb the mass exodus and prices dropped exponentially.
The collapse raised questions, pleas, and confusion, but it also provided a poignant example of a fundamental problem in designing cryptocurrencies: how to align incentives between the various stakeholders who build, use, and maintain an open protocol. It was hoped that Terra’s community would be strong enough to come together to save the protocol, but ultimately the fear of financial loss led people to flee.
The future of algorithmic stablecoins
None of this is to say that algorithmic stablecoins can’t work. Amidst the fallout following an event like the collapse of UST, the focus tends to shift to two areas:
- Responsibilities to investors
- The acknowledgment and correction of mistakes
While protocol hacks have become more frequent, with many leaving the protocol broken, some managed to retain their communities through open dialogue and compensation plans that demonstrated commitment and accountability.
In 2020, Origin Dollar (OUSD) fell victim to a flashloan and reentrancy attack that saw the protocol drained of over $8 million in user and treasury funds. The team responded immediately, and soon posted a plan to compensate 100% of the user funds lost in the attack.
We’ll have to see whether or not Terraform Labs will make investors whole but the effects of the debacle can already be seen in the posts of the r/terraluna subreddit.
Meanwhile, proposals about how to handle the situation are being made and voted on in Terra’s Research Forum.
4/ Now the important part.
To lead by example on PROTECTING USERS, Binance will let this go and ask the Terra project team to compensate the retails users first, Binance last, if ever.
Binance (after a 5 min discussion) fully support this proposal. ?https://t.co/QnMx8aZ09A
— CZ ? Binance (@cz_binance) May 16, 2022
Mistakes are to be expected – especially in an emerging field like DeFi – but how projects handle these mistakes matters just as much, if not more than the mistakes themselves.
That said, UST left itself exposed by embracing tokenomics that contained a known, fatal vulnerability. Network security was an afterthought, and for a stablecoin – the security of the peg is paramount.
Algorithmic stablecoins using the same strategy as Terra will be vulnerable to the same type of attack. Collateralized stablecoins and those taking a hybrid approach have their risks as well but don’t face the same vulnerability.
Hybrid stablecoins like FRAX combine elements of algorithmic and collateralized stablecoins. At the time of writing, 89% of FRAX is backed by digital assets, leaving only 11% unbacked. This liquidity provides the protocol with levers that help shield its peg from attack.
As UST’s price fell, its liquidity on external markets was quickly depleted. The same attack on a stablecoin like FRAX would be much more expensive and comes with no guarantee of success for two main reasons:
- As the value held in its Treasury is far closer to the total supply of outstanding FXS, the protocol is far less likely to be forced into liquidation.
- In the event of an attack, FRAX would need to find liquidity or funding to back 11% of the FRAX total supply.
Terralabs had only accumulated around $2 billion in Bitcoin to support a $40 billion network before UST was depegged. In other words, while algorithmic, FRAX was still designed with network security that makes it far less attractive to potential attackers.
The collapse of UST and LUNA is an unfortunate example of the consequences of building an exploitable financial system. While the consequences have been devastating for some investors, such hardships help steer the stablecoin community in a more sustainable direction.
Those who fail to learn from history may be doomed to repeat it, but those who heed its lessons can reap valuable rewards.
Stably Prime makes it easy to access a variety of different stablecoins. Please visit https://prime.stably.io/ to get started or head to https://www.stably.io/ for more information about Stably’s borderless accounts, Stably USD (USDS), and Asset-Tokenization-as-a-Service.
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