What happens when you down a peg?
Over the last 24 hours, the stablecoin terraUSD was depegged from the price of $1, and the price of the counterbalancing token, Luna, is down ~40%. In this post, we unpack the circumstances behind it
Before we get to the circumstances surrounding the Terra protocol yesterday, it’s probably helpful to recap a few basics - what is a stablecoin? What is the Terra protocol and the Luna token? And why is this important to you?
And then we’ll cover the events that transpired over the last few days
What is a stablecoin?
So let’s start at the very beginning - a stablecoin is a virtual digital asset that tracks the price of a fiat currency. So 1 unit of the token will be worth 1 unit of the underlying currency, most commonly tracking the United States Dollar.
Stablecoins offers the stability of a fiat currency, and the benefits of a digital asset namely, an immutable ledger, faster transaction times, lower fees, etc.
Stablecoins have an incredibly large market capitalization today. The top 3 stablecoins (USDT, USDC, and Binance USD) have a combined market cap of $150B+. And there’s a long tail of several other stablecoins as well. You can track them here - https://coinmarketcap.com/view/stablecoin/
Our story concerns the fourth largest stablecoin - terraUSD or UST (not to be confused with Tether, or USDT, which is the largest).
What is UST, terra protocol and the Luna token?
TerraUSD is an algorithmic stablecoin that was floated by the Terra protocol (terra.money). Notice the word ‘algorithmic’. Let’s dig a little deeper into that first:
There are two ways to peg the value to a currency at a fixed rate:
Asset reserves - This is the most typical method, and generally used by more than 50 countries as well, who peg their currencies to the US Dollar.
For example, Qatar pegs their currency, the Qatari Riyal at 3.64 Riyals to 1 USD. And they hold a lot of USD as reserves. So if the demand for the riyal drops, therefore reducing its value, the Reserve bank of Qatar sells USD and buys Riyal to stablize the price. And vice-versa. This is the typical asset reserve method, and it’s followed by the top stablecoins.
Algorithmic rules - Instead of holding reserves, algorithmic stablecoins peg the value of the asset using a set of rules that create arbitrage opportunities, so that market forces will nullify any movement from the peg value. If this was confusing, we’ll explain with an example of how it works below
The Terra protocol follows the second method. And it does so, with the help of two tokens, Terra and Luna (latin translations for Earth and Moon respectively)
Terra are the stablecoin tokens that track the price of the underlying currency e.g. terraUSD tracks the United States Dollar. (There are other stablecoins as well e.g. terraSDR). More details are available on their website
Luna is the native token of the protocol. It acts as the stablizer for volatility on Terra, and is used for governance and staking rewards for validators on the protocol.
How does it work?
Imagine two big jars of tokens - one for Terra, and one for Luna. The protocol always allows users to always exchange 1 UST token FOR $1 worth of the Luna token, and vice-versa
For example, say the value of 1 Luna token is $50. If I want to mint 1 UST, I will need to burn 0.02 (or 1/50) of the Luna token. And similarly, burning 1 UST will net me 0.02 of the Luna token.
Now imagine two situations:
UST is trading 1% above USDollar i.e. at $1.01 - In this case, market participants can quickly burn $1 worth of Luna (or 0.02 Luna) for 1 UST. Then they can sell the UST in the open market, and receive $1.01, thereby netting a riskless profit of $0.01. Because arbitrageurs will quickly do this, the supply of UST will go up, reducing its price and bringing it down to the peg value of $1.
UST is trading 1% below USDollar i.e. at $0.99 - In this case, market participants can buy 1 UST at $0.99, then burn the 1 UST to mint $1 worth of Luna, thereby netting a riskless profit of $0.01 again. And again, because arbitrageurs will quickly do this, the supply of UST will go down from burning, increasing its price, and bringing it up to the peg value of $1.
All of this information is much better explained in the documentation of the Terra protocol here. It’s a good read - https://docs.terra.money/docs/learn/protocol.html.
Now why would someone hold UST today? Well, that’s where the Anchor reserve protocol comes. The anchor reserve offers a staggering 20% APY to stake your UST with the protocol. 20% is an insane yield, many times the yield on the US dollar (T-bills). So how and why are they providing this?
Here’s where the Luna Foundation Guard comes in. In paper, the operation is simple:
Issue a lot of Luna tokens to the LFG treasury
Burn Luna to mint UST and fund the Anchor reserve
Luna burned for minting UST by users
UST staked on Anchor with returns paid by the reserve
Luna price goes up as more people use the protocol
Sell more Luna from treasury to further fund the reserve
It’s meant to be a initial impetus to jump start the protocol’s flywheel. Over time, with scale, the stablecoin will have massive scale, additional use-cases, so the incentive paid out to hold will be reduced.
(To be fair, at this time though, this has some shades of a complicated ponzi scheme)
So what happened recently?
Let’s dig deeper into the same situation outlined above. This is all hunky-dory in a bull market. But take the situation of a bear market now, where there is large selling pressure on all tokens.
Luna token price sees downward pressure
Users worry about depeg (i.e. reduction of value vis-a-vis $1) and ability to pay out APY by the reserve
Users burn UST and mint Luna to sell it
Luna spikes in volume
Luna sees further price reduction
Just as the bull market scenario has a positive flywheel, this has a death spiral. These effects are quite common to any system that has network effects (at this point, I’d also really recommend reading The Cold Start Problem by Andrew Chen - it’s a masterpiece on this subject)
This is in effect what’s happening today. The Terra ecosystem is seeing massive selling pressure on both UST and Luna, leading to a massive crash in the Luna price, and depeg of the UST
UST depeg - As I’m writing this, UST is valued at $0.8255 (18% below the peg value). Track it here - https://coinmarketcap.com/currencies/terrausd/
Luna price drop - Luna is down 50%+ and is continuing to see downward pressure. Track it here - https://coinmarketcap.com/currencies/terra-luna/
At this point, the Luna Foundation Guard has now activated an active defense of the peg. One of the key things they’ve done is built an alternate way to convert UST to BTC. This reduces the downward price pressure on Luna as there’s an alternate exit path, thereby arresting the death spiral. More details on their actions are available on this tweet -
I’m not an expert on the forces at play here. For more detail, I strongly recommend reading this excellent thread, and the child threads referred by the gentleman. Truly a remarkable analysis -
Why is this important to you?
In the recent times, we’ve seen a rapid rise in several protocols, and companies who offer returns of >12% by investing money in stablecoins. There’s generally a lot of opacity around where and how this is invested, but for most, the Anchor protocol was a big source of the yield.
The math works out - a big chunk is staked in protocols such as Anchor for a 20% yield, with minor portfolio balancing in bluechip tokens like Ethereum (for a 3-5% yield). 10%+ is paid out to the investors, with the remaining retained by the company.
The problem is that stablecoins (as what happened with Terra), may always not be stable. Any depegs here from the $1 mark, can result in huge drawdowns on the position value, and consequently, the value of your investments
So buyer beware here! High returns almost always carry enormous risk associated with them. And these protocols are inherently experimentative and volatile.