Luna: Not All Stablecoins Are Created Equal

Thesis Summary

Terra’s Luna (LUNA-USD) has lost over 99% of its value in a matter of days. Furthermore, USTerra (UST-USD), Terra’s algorithmic stablecoin currently trades at a mere $0.12. Before the crash, UST was the 10th largest crypto by market cap, so it’s not surprising that this has shaken the crypto market.

But what happened to LUNA and UST? Are all algorithmic coins doomed to fail? 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?

Luna and USTs demise came as a surprise to most investors, including myself. In my last article on LUNA, I talked about LUNA’s potential, expressing my belief that the price would head higher. While I was well aware of the shortcoming of algorithmic coins, LUNA’s success seemed to suggest that, perhaps there was room for them in the crypto market. Clearly, I was mistaken. Algorithmic coins require a level of demand that cannot be guaranteed, and they will always be liable to events like the one we saw last week.

In hindsight, there were some warning signs over the last few weeks that made it clear that LUNA and UST were about to collapse.

The key here is to answer the question, why did people own UST in the first place? And the answer is to receive “dollar equivalent” yields of up to 20%. Before UST’s implosion, Anchor, Luna’s lending and borrowing protocol held over 72% of the UST in circulation.

In the beginning, UST staked in anchor could yield up to 20%, but this interest slowly came down, as more people came to lend UST than to borrow. Furthermore, following the passing of Proposal 20 back in March, every time Anchor’s reserves increased by 5%, the interest was reduced.

On May 6, there was roughly 14 billion UST in Anchor, but this came down to 11.7 billion over the weekend, and at this point, UST was still pegged to the dollar.

However, as the mass exit continued, problems began to emerge due to the way that this exit took place. There are two ways of selling UST. Exchanging it for LUNA burn-and-mint mechanism or selling it in the open market.

So, those selling UST for LUNA were causing the supply of LUNA to inflate, which put downward pressure on the coin. This can be seen in the charts below.

On May 8, LUNA had a supply of 343 million. By May 12, that figure was 32.3 billion.

On the other hand, those selling UST to the open market were causing the UST to depeg. Initially, UST started trading at $0.98, which created an arbitrage opportunity. People started taking their UST to liquidity pools, mainly on Curve Finance, to make a profit. Generally, a liquidity pool in curve finance will treat UST the same as USDT, for example. These pools are in fact mechanisms of maintaining equilibrium between these stablecoins, but this eventually contributed to UST’s undoing.

Suddenly, these liquidity pools had too much UST. To balance the pools, Curve Finance did what it always does, and began offering UST at a discount to incentivize arbiters to make the opposite trade, i.e. sell other stablecoins to buy UST/take them out of the pool. However, arbitrageurs did not take this trade. Perhaps it’s because they saw the crashing LUNA price. There were also other contributing factors, like very large and “unusual” trades that took place, which have ignited conspiracy theories.

In any case, a death spiral finally took place. As LUNA’s price goes down, more LUNA must be minted to exchange UST for $1 of LUNA. This in turn increases the supply which reduces the price and so on. Eventually, the market cap of LUNA fell below that of UST, which meant game over for the algorithmic stablecoin.

USDT, USDC and DAI

While USTerra crashed, other stablecoins were caught in the storm, though some seemed to benefit from this. The three main stablecoins, USDT, USDC and DAI “experienced” the UST crash in different ways. Let’s begin with USDT:

Above we can see USDT’s price and market cap. We can see that USDT depegged strongly on the 12th of May. This also coincided with almost $3 billion in withdrawals. And while the peg has been maintained USDT has lost almost $10 billion in market cap.

Not the case with USDC:

USDC began trading at a premium for a while, and its market cap has exploded in the last week.

Lastly, we have DAI:

DAI experienced something in between. We see the peg both go above and below its target level. We also see that the market cap has decreased significantly, but it seems to be recovering in the last few days.

Not all Stablecoins are Created Equal

The collapse of UST created a lot of uncertainty around stablecoins but also left an opening in the market.

USDT is still the largest stablecoin, now closely followed by USDC, but it is clear that it is perceived as “weaker” by investors. USDT and USDC are quite similar in terms of operations, 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 fire last year for not being “100% backed by dollars”. In response to this, USDC claims it is now backed only by USD and short-term treasuries. Meanwhile, USDT released its holdings, and it had a lot of assets that are not dollars or US debt. A big chunk of their assets is “commercial paper” which really could mean anything. However, USDT CEO recently revealed that commercial paper has been reduced by 50%, in favour of US Treasuries.

The other issue is that USDT is run by iFinex, the Hong Kong-registered company that also owns the crypto exchange BitFinex. Meanwhile, Circle, which operates USDC is an American Boston based company, which has recently received investment from Blackrock and Fidelity.

Meanwhile, DAI, which is much smaller than the other two, is run by MakerDAO a “peer-to-peer organization created on the Ethereum network to allow people to lend and borrow using cryptocurrencies”. DAI is therefore decentralized, and decisions are made democratically amongst holders of the MKR token. DAI is backed by overcollateralized loans on its exchange. Most of these are denominated in ETH, but USDC, for example, also makes up a large chunk of these. Generally, this is enough to maintain the peg, but in 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 has highlighted many issues, let’s sum them up here.

First off, algorithmic coins are not viable at this point. They can only work with a minimum level of demand, and this cannot be guaranteed.

Also, not all stablecoins are created equal. The market is favoring USDC over USDT for example. But are these stablecoins safe? I believe the fact that we have seen these coins maintain their peg even after these extreme situations is strong evidence of this. The fact that they are not backed 100% by hard cash does not worry me. This is the way banks and even central banks operate, and I discussed this more in-depth here.

Lastly, the issue of governance seems important here. USDT is controlled by a foreign entity, while USDC is “American controlled” which some investors seem to prefer. Meanwhile, DAI is a decentralized coin, which does seem fundamentally more attractive. Though given that it is backed by a mix of assets, it is less clear how stable it is.