DeFi Insight: The Meltdown of Terra UST Stablecoin

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The crypto market is experiencing one of the biggest meltdowns in history. As of the writing of this article, everything is still unfolding. Such crashes always put a strain on newly developed DeFi protocols and stablecoins as these often rely on market liquidity and stability. TerraUSD (UST) is an algorithmic stablecoin pegged to USD but not backed by USD. On the 5th of May, UST lost its peg to the US dollar and has been struggling to recover ever since. Being one of the best known DeFi projects, Terra has raised doubts about other DeFi protocols.

Authors: Valentin Kalinov, Christian Viehof

There are two types of tokens in the Terra protocol: all Terra stablecoins and the native blockchain token Luna (LUNA). The role of LUNA is to absorb the price volatility of UST. The basic rule of the protocol is: Users burn LUNA to mint UST and burn UST to mint LUNA. If the value of UST rises above the peg, users can burn one dollar worth of LUNA for one UST. When the price of UST drops below one dollar, investors burn UST for one US dollar worth of LUNA, leading to supply reduction of UST. The goal of the protocol is to maintain the one-dollar peg. If UST trades above a dollar, it is relatively easy to return to the peg; the protocol burns LUNA to create more UST. The biggest challenge for an algorithmic stablecoin is to maintain its peg in a market meltdown. Many algorithmic stablecoins have entered into a death spiral and never recovered. Examples of such stablecoins are Empty Set Dollar, NuBits and Basis Cash. The aim of algorithmic stablecoins is to not rely on a centralized entity to maintain the peg. The design of these protocols requires developers to take some risks. Unfortunately, the algo space is still too young and lacks experience in how to design a resilient solution. UST lost its peg on the 5th of May and entered a death spiral.

Figure 1: Innovation vs Volatility in algorithmic stablecoins (Source: https://blog.kalinoff.com/)

The controversial Anchor protocol, which is part of the Terra ecosystem, has been providing tempting yields to UST deposits. Anchor has been subsidizing the yields in order to lure investors into depositing UST into the protocol. It can be argued that because of Anchor UST gained such popularity and high adoption. As the crash began, the Total Value Locked (TVL) in the Terra protocol quickly went from $30 billion to $2 billion in a day.

Figure 2: TVL on Terra (source: https://defillama.com/chain/Terra)

The Meltdown

Algorithmic stablecoins often rely on some kind of market buy/sell mechanism to maintain their peg. In market meltdowns and black swan events, buyers often lose faith in the underlying asset. In the case of UST, there were not enough LUNA buyers to absorb the additional supply. Let’s go back in time and analyze notable events in Terra’s history:

  • UST has experienced de-pegging twice before: in December 2020 and in May 2021.
Figure 2: UST price chart (Source: https://coinmarketcap.com/currencies/terrausd/ )
  • Back in July 2021, Terra protocol injected $70,000,000 UST into Anchor because it was at risk of running out of funds. This was a warning sign for investors who see Anchor’s yields as unsustainable long term. The news went unnoticed by many.
  • In March 2022, Terra announced the purchase of $10 Billion worth of Bitcoin. The idea was to have BTC serve as a reserve asset for UST. Terra was forced to sell their BTC in an attempt to save the peg. In the last few days, Luna Foundation sold all 42,530 of its BTC and pushed the BTC price to even lower levels which further dragged down the entire crypto market.
  • On April 1st 2022, Terra announced the 4pool. The 4pool was a new Curve pool composed of UST, FRAX, USDC, and USDT. At the time of the announcement, the 3pool on Curve was the dominant one, and Terra was about to migrate to the 4pool. Terra had to withdraw liquidity from the 3pool in order to transfer it to the 4pool. During that time, the UST peg was susceptible to attacks because of the low liquidity.
Figure 3: 4pool Curve Balance. (Source: https://dune.com/)

The attack started on March 27th: While Terra was buying 20k BTC unknown player borrowed 100k BTC to sell into Terra’s purchasing of bitcoins. After selling into the market, the attacker had $1 billion at their disposal to attack the peg. On May 7th, they started selling UST into the Curve pool, which forced the price to steer down. The Terra Foundation was forced to start selling Bitcoin in order to defend the peg. The problem is that the BTC they purchased had already lost in value because of the crypto market downtrend. Bitcoin at the time of purchase was $42k, and by the time they had to sell, it was already sitting at $34k. While Terra was defending the peg, the attacker moved to Binance and started selling the remainder of their UST (around $600m). This is where UST started falling under $0.98 and lost the peg.

Figure 4: Binance UST/USDT order book.

The selloff triggers a negative feedback loop, and everybody begins panic selling. Investors wanting to reduce their exposure to LUNA start selling LUNA tokens on the market, and UST holders start redeeming their UST for LUNA, which triggers an enormous rise in the supply of LUNA. At the time of writing, the price for LUNA was around 1 cent, while a few weeks ago, the price was hovering around 100 US dollars. With Terra at around $0.01 to redeem $1 billion UST (less than 10% of the 12 billion needed to restore the peg), the system would need to print another 100 billion LUNA tokens. For perspective, 300 million have been in circulation three days ago.

Conclusion

Terra played a big role in the DeFi ecosystem and was one of the most recognized projects in the crypto space. The fall of Terra will leave a significant mark on the ecosystem and the justification of DeFi as an alternative to the existing financial markets. The eyes of regulators are also pointed at what happened in recent days. It is expected that in the future, we might see stricter regulation around stablecoins because of this event. While Terra was crashing, another algorithmic stablecoin also lost its peg to the US dollar: USDN. USDN has lost its peg for the second time in the past few weeks. For now, it is back to the drawing board for many algorithmic coins. Events like this make crypto more resilient. There are many lessons to be learned from the last few days.

The classification of UST according to the ITC:

Figure 5: The UST Tokenbase entry (Source: https://itin.itsa.global/YMJX3H8H5)

Economic Purpose (EEP): UST is listed as a fiat-pegged payment token (EEP21PP01USD) similar to the other stablecoins in the industry.

Industry Type (EIN): The issuer of UST is active in the field of Payment Services and Infrastructure (EIN06PS).

Technological Setup (TTS): UST is a Ledger Native Token (TTS4BC).

Legal Clam (LLC): The UST token does not entitle its holder to any legal claim or rights against the issuing organization therefore it is listed as a No-Claim Token (LLC31).

Issuer Type (LIT): The dimension “Issuer Type” provides information on the nature of the issuer of the token. The Terra infrastructure is built by Terra Form Labs, but UST as a stablecoin is an Entity without Legal Personallity (LIT62DL).

Regulatory Framework (EU) (REU): The dimension “Regulatory Status EU” provides information on the potential classification of a token according to the European Commission’s proposal for a Regulation on Markets in Crypto Assets (MiCA, Regulation Proposal COM/2020/593 final). The UST token qualifies as a Crypto Asset out of Scope of MiCA (REU52) according to the definition provided in Article 3 (5) of Regulation Proposal COM/2020/593 final.

List of all Terra tokens:

Figure 3: Tokenbase list with all Terra tokens (Source: https://api.itsa.global)

The International Token Standardization Association (ITSA) e.V.

The International Token Standardization Association (ITSA) e.V. is a not-for-profit association of German law that aims at promoting the development and implementation of comprehensive market standards for the identification, classification, and analysis of DLT- and blockchain-based cryptographic tokens. As an independent industry membership body, ITSA unites over 100 international associated founding members from various interest groups. In order to increase transparency and safety on global token markets, ITSA currently develops and implements the International Token Identification Number (ITIN) as a market standard for the identification of cryptographic tokens, the International Token Classification (ITC) as a standard framework for the classification of cryptographic tokens according to their inherent characteristics. ITSA then adds the identified and classified token to the world’s largest register for tokens in our Tokenbase.

  • The International Token Identification Number (ITIN) is a 9-digit alphanumeric technical identifier for both fungible and non-fungible DLT-based tokens. Thanks to its underlying Uniform Token Locator (UTL), ITIN presents a unique and fork-resilient identification of tokens. The ITIN also allows for the connecting and matching of other media and data to the token, such as legal contracts or price data, and increases safety and operational transparency when handling these tokens.
  • The International Token Classification (ITC) is a multi-dimensional, expandable framework for the classification of tokens. Current dimensions include technological, economic, legal, and regulatory dimensions with multiple sub-dimensions. By mid-2021, there will be at least two new dimensions added, including a tax dimension. So far, our classification framework has been applied to 99% of the token market according to the market capitalization of classified tokens.
  • ITSA’s Tokenbase currently holds data on over 4000 tokens. Tokenbase is a holistic database for the analysis of tokens and combines our identification and classification data with market and blockchain data from external providers. Third-party data of several partners is already integrated, and API access is also in development.

Remarks

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Valentin Kalinov is an Executive Director at International Token Standardization Association (ITSA) e.V., working to create the world’s largest token database, including a classification framework and unique token identifiers and locators. He has over five years of experience working at BlockchainHub Berlin in content creation and token analysis, as a project manager at the Research Institute for Cryptoeconomics at the Vienna University of Economics and token analyst at Token Kitchen. You can contact Valentin via valentin.kalinov@itsa.global and connect on Linkedin if you would like to further discuss ITSA e.V. or have any other open questions.

Christian Viehof is an Executive Director at the International Token Standardization Association (ITSA) e.V., working to create the world’s largest token database including a classification framework and unique token identifiers and locators. He completed his Bachelor in Economics at the University of Bonn, the Hong Kong University and the London School of Economics and Political Science with a focus on Behavioral Economics and Finance. Currently pursuing his Master of Finance at the Frankfurt School of Finance and Management, you can contact him via christian.viehof@itsa.global and connect with him on Linkedin, if you would like to further discuss ITSA e.V. or have any open questions.

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International Token Standardization Association

The International Token Standardization Association (ITSA) is a not for profit organization working on holistic market standards for the global token economy.