Analysis of UST/Luna - Digital Cash GmbH

Market situation

A price drop in the emerging US dollar stablecoin “UST” in May 2022 has recently led to uncertainty among stablecoin investors.1 With this market overview, we, as a provider of serious solutions in the segment of digital and tokenised currencies, would like to clarify between the different forms of stablecoins and work out why stablecoins cannot be equally stable. The term “stablecoin” implies a stability that is often not given, so that a precise analysis is necessary.

Under normal market conditions, the stablecoin should always trade at parity, i.e. exactly $1 for the US dollar. However, at the beginning of the market turbulence, the trading level for Terra’s UST stablecoin was $0.26 instead of one US dollar; at that time, Terra was still one of the 10 most valuable cryptocurrencies in the crypto ecosystem.2 Within a few days, however, the price of this so-called governance token “LUNA” has fallen from just under $100 to $0.0001734 – as of 18 May 2022.3 The price of a UST is now only $0.06.4 In total, according to Bloomberg, hundreds of billions in market value of crypto assets were destroyed in the process (“$270 trillion meltdown”).5 Terra’s UST alone accounted for $45 billion of the equivalent value.6 In the following, we will explore what defines a stablecoin, what the main classifications are and how this “crash” came about.

“Why Stablecoin is not the same as Stablecoin and why the Digital Cash Euro Token is the anchor of stability for the market and its demand.”

Taxonomy and definition

A stablecoin is a cryptocurrency that is linked to the price of another asset, usually another currency. The definition for this coupling is price parity, i.e. one token corresponds to one currency unit, e.g. one US dollar.

The price stability mechanism can be established in several ways, which are presented below. The volatility of the underlying value can be seen as a measure of stability. The respective underlying is also referred to as “backing” and is defined by the relationship of one unit of token to one unit of underlying. (Example: a gold token is always backed by one gram of fine gold.) As in the traditional currency market, the price stability of this underlying is relevant here.

In the specific taxonomy, a differentiation must be made between the following four types – in the order from tending to stable to tending to unstable:

Physically-backed
Credit-backed
Algorithmically
Trust-backed

Physically-backed

Physically backed stablecoins are tokens that are backed 1:1 by another good, value or asset, which is often a commodity with stable value such as the precious metal gold. The Euro Token (DCE) also falls into this category, as each token is backed by one euro.

In this category, the first decisive factor is how the so-called “pegging” works, i.e. the coupling of token and collateralisation. Secondly, it is relevant how the underlying is stored and kept – in this respect, security and costs are decisive.

Credit-backed

Credit-backed categories are stablecoins that are backed by claims (typically recognised as debt). These claims can be directed at external debtors such as states or companies, for example in the case of bonds or commercial papers that serve as the underlying. This is the case with Tether, the stablecoin “USDT”.

There are various variants on the market that are collateralised with money market funds. What they all have in common is the risk of default (credit risk).

If a critical mass of investment volume accumulates, a similar problem arises as with the asset-backed securities (ABS) of the 2007 financial crisis. A large demand for high-interest forms of investment such as commercial paper are disproportionately in demand and thus bundled in a money market fund-like construct such as Tether.7

The Diem project (formerly LIBRA) by Meta (formerly Facebook) also falls into this category, since before the sale of the project it was planned to collateralise the stablecoin with various securities such as bonds.

Stablecoins backed by conventional book money through banks (giro money) also fall into this category, as there is a default risk of the institution keeping the books (counterparty risk).

Algorithmically (backed)

Synthetic or algorithmic stablecoins do not work with direct “pegging”, but the price stability mechanism works on the basis of programmed heuristics. Basically, if the price falls below the defined threshold (e.g. $1), the underlying is sold against the stablecoin token and sold again if it exceeds it, so that the price settles at the desired price threshold.

A distinction must now be made between unbacked, algorithmic stablecoins such as IRON Finance, Empty Set Dollar or Terra LUNA’s UST and the stablecoins backed mostly by cryptocurrency such as “DAI”. MaderDAO’s stablecoin “DAI” works with “Ethereum-based assets” as underlying, these are usually always “over-collateralised”, so that more collateral must be deposited than money creation in order to compensate for price fluctuations.8

There are also hybrid forms that work algorithmically but invest credit-based, such as TrueUSD (TUSD).

Algorithmically (not backed)

The idea behind uncollateralised, algorithmic stablecoins is capital efficiency. No “dead capital” is to be deposited as collateral, but rather value stability is to be achieved as far as possible without collateralisation. This price stability mechanism works well as long as the fluctuations are minimal and the underlying medium of exchange (LUNA as a swap) has a stable value.

LUNA’s Terra stablecoin “UST” works by creating (“mining”) new LUNA tokens and selling them off, while vice versa also destroying (“birthing”) LUNA tokens to maintain price stability. 9

If the price of the UST falls below one dollar, the money supply of the UST is reduced by burning a UST and mining a LUNA. This works as a swap in the exchange principle both off-chain on the crypto exchanges and on-chain with the Terra protocol. If the price of the UST rises above one dollar, the money supply of the UST is increased again by mining a UST for a born LUNA.10

In summary, it can be said that the algorithmic stablecoins work either with no crypto-collateral or with crypto-collateral, which is also the case with “DAI”, and automatically realise parity through swaps or arbitrage (buying and selling in the market) via smart contracts.

Trust-backed

Trust-based stablecoins are not collateralised and are thus issued by trustworthy private or public institutions, which thus imply the underlying countervalue.

DLT-based central bank digital currencies (CBDC) fall into this category, as they are not subject to any explicit collateralisation – analogous to the conventional FIAT currency. Here, the market’s trust in (i) the basic social order and (ii) the economic strength of the issuers serves as an implicit underlying. In addition, (iii) confidence in the integrity of the issuers is also required (governance).

Most central banks do not use distrubuted ledger technology or even permissionless crypto, although there are positive exceptions such as the Banque de France.11

Another example is the use of a digital euro in the EIB issue in April 2021.12

Finally, it should be noted for this category that from a historical perspective, most currencies were pegged with another value. Unfunded FIAT currencies are a historical novelty. It was only in the last century, or after the abandonment of the gold standard in 1971, that price stability was debated.13

„As the Digital Euro Token is a 100% collateralised token, unlike Terras’ UST, there is no comparability and a similar “crash” scenario is ruled out due to the cash reserve deposited in the vault.“

What makes LUNA’s UST special?

First of all, it should be noted that the UST is not the first of its kind, but that there have already been various unsecured, algorithmic stablecoins. Empty Set Dollar, Ampleforth, Basis Cash or IRON Finance’s TITAN should be mentioned here in particular. The latter TITAN and IRON had the same principle as Terra LUNA and UST, both were exchanged against each other (“swap”) and it finally ended in a hyperinflation of the governance token where both tokens became worthless. 14

The UST Stablecoin promised a US dollar stablecoin, founded by Terraform Labs, which has been working on its own blockchain network for stablecoins since 2018. The target image and vision was a “decentralised bank”, ergo a distributed and crypto-based variant of easily exchangeable FIAT stablecoins.

This project became particularly popular due to the high interest paid on the underlying LUNA token during staking, as well as the public support of some large market participants such as Galaxy. Up to 20% interest was distributed annually.15 The “Anchor Protocol” established by LUNA as a “decentralised central bank” should only be mentioned in passing in this context, as should the Mirror Protocol, which allows assets such as shares to be replicated synthetically and is said to have led to an enormously high UST demand.

Already in February of this year there had been news suggesting that the constellation of LUNA and UST could be a “Ponzi”. 16

The price collapse finally occurred when large volumes of USTs were sold, the price moved below $1, so USTs were withdrawn to artificially tighten the money supply, but this now generated new LUNA and artificially expanded the money supply. After significant dilution (inflation) occurred here, a downward price spiral (“death spiral”) was triggered.17 The existing inflation was exacerbated by the planned hyperinflation, suggested by a so-called “proposal” of the founder Do Kwon.18 He should have known what he was doing, after all, he had apparently already founded the US dollar stablecoin Basis Cash (“BAC”), which also collapsed.19

The “#LUNAtic community”, as Terra calls itself on its website, had to stop the specially created blockchain after the collapse of parity and thus also of the LUNA token price.20 This is particularly perfidious, because a permissionless DLT should not be able to be stopped at all, but should act fail-safe.

Regardless of whether this vulnerability inherent in the system was deliberately exploited or resulted from investor dynamics, it ultimately plays a subordinate role; the collapse was a matter of time, as the protocol itself was not “stable”.

Some have described the UST crash as a first digital bank run, but this would assume the deposit-taking function of a regulated bank, which is not the case with Terra, although some investors may have used the Anchor Protocol as a highly liquid investment.

For the sake of completeness, it should be mentioned that the funding of Terra was almost exclusively through private token sales and only a small portion of four percent was circulated in public sales, which does not speak for decentralisation. Moreover, only 20 per cent was earmarked for “stability reserves”.21

Ultimately, it comes down to the question of whether the stablecoin is sufficiently collateralised (quantitatively) and sufficiently stable in terms of value stability (qualitatively).

A surrender claim on a coin or token is worthless if the underlying asset becomes worthless.

For the sake of completeness, it should be mentioned that fluctuations around the defined target value occur during price determination, analogous to the tracking error in an ETF. This explains why stablecoins are never traded exactly at $1, but slightly above or below it depending on supply and demand.

Conclusions

It is important to understand that not all stablecoins are the same. It is important to differentiate between the different types. Many market participants still lack the necessary intuition and market knowledge for this. The underlying thesis of this popular opinion is that stablecoins are not stable per se and therefore represent a risk for investors and the financial ecosystem. In this market overview, we argue that not every coin that claims to be stable is actually stable in price. Moreover, there is a demand for genuinely stable tokens, which, unlike Tethers’ USDT, must not represent a money market fund-like construct, as these in turn invest in debt instruments that are at risk of default. While the latter has the great advantage of being able to earn interest, it has the inherent disadvantage that there is a default risk. Precisely this problem is solved with a financial instrument that tokenises cash directly.

In this context, it is interesting that Tethers’ USDT also lost more than 5% of its own value in the course of the “crash” and was only traded at $0.9485. Although this circumstance did not last long, it shows that some market participants do not trust the world’s largest stablecoin.22