Paxos: Understanding the demise of UST and what makes a stablecoin stable

Terra: Unstable Value

Stablecoins are digital tokens backed by stable assets such as the US dollar, and were originally created for crypto investors to have an easy on- and off- ramp between fiat currencies and crypto. As stablecoin usage and market cap have increased, so has regulatory scrutiny. In particular, the reserve practices (or lack thereof) of various stablecoins have increasingly been in the spotlight – which brings us to the algorithmic stablecoin at the heart of the Terra ecosystem, UST.

UST was until very recently the #3 stablecoin by market capitalization in the entire crypto sector, topping out at $18.7B outstanding as of May 6, 2022. The status of UST has gone in a completely different direction over the last few days, moving from $18.7B to $10.4B market cap as of May 11:

To be clear, UST, an attempt at an algorithmic stablecoin pegged to $1, has spent the past two days trading between $0.30 and $0.90, with massive volatility. This is not stable by any conventional definition of the word. LUNA, the main token for the chain and the UST project, also traded to nearly zero. $30B of value is completely gone.

How did this disaster happen? Let us look at the mechanics of UST.

Minting, Burning, Arbitrage and the Danger of Assumptions

How is UST created? This simple question is at the heart of the entire problem. To create one UST, a wallet burns $1 of LUNA, and one UST3 appears in that wallet instead. This mechanism means that each time UST is created, LUNA is burned, reducing the available supply. In return, the supply of UST expands as UST is minted.

How is UST destroyed? The mechanics are the opposite of creation. To destroy one UST, a wallet burns one UST, and $1 of LUNA appears in that wallet instead. This mechanism means that each time UST is destroyed, LUNA is minted, increasing the available supply. In return, the supply of UST reduces as UST is burned.

In regularly functioning markets, this gives rise to a relationship that allows the coin to hold its peg through arbitrage.

The key point is the demand for LUNA. If that were to collapse, the entire system crumbles. Without a deep and liquid orderbook for LUNA, the peg cannot be maintained, because the arbitrage mechanism ceases to function.

From November 2020 until May of 2022, the system largely worked. In December of 2020, when UST had less than $1B outstanding, and in May of 2021, when the entire crypto market was crashing, UST had temporary de-peg events into the 0.85 and 0.95 ranges, respectively, but in each case the arbitrage mechanism appeared to restore order over time and the peg recovered.

Importantly, there is no reserve in the traditional sense of a fiat-backed stablecoin here. There is no cash in bank accounts, no short-term USTs, no commercial paper, and no stocks or bonds. The arbitrage mechanism is bearing 100% of the weight in terms of the formal maintenance of the peg. If it fails, the system fails.

How Did Terraform Labs Build Demand for UST?

To understand the collapse, one has to understand the demand for UST and what could have caused that demand to reverse in rapid and disorderly fashion. UST has been marketed as a next generation stablecoin by Terraform Labs, the entity behind it, for two separate reasons:

Censorship resistance.

Terraform Labs claimed that as a decentralized stablecoin with no reserve, UST had no single point of vulnerability to a financial regulator or bad actor. There was no reserve to be interdicted, frozen or stolen. There was no issuer monitoring use of the tokens, or cooperating with law enforcement to freeze and/or seize tokens that were used in violation of law. Without this central point of theoretical failure, Terraform Labs claimed that UST could provide a buffer against negative outcomes in the crypto markets.

Cross-chain utility.

While UST was the central token of the LUNA chain, UST could also be found on ETH, BNB, SOL, FTM, AVAX, OSMO, and others. Terraform Labs claimed that UST was so ubiquitous that it was being put into the main pool of Curve, an important crossroads for stablecoins in the DeFi ecosystem, where hundreds of thousands to millions of users trade one stablecoin for another daily.

Unfortunately, UST has not been able to live up to these promises.

Of the $18.7B of UST outstanding on May 6, approximately $14B of it was to be found in Anchor Protocol, an application running on the Terra blockchain. Anchor protocol is effectively a decentralized bank. It allows users to deposit only UST and take loans in UST, collateralized by any number of tokens that could be staked (LUNA, ETH, and AVAX, most notably). The importance of the collateral choice was that Anchor only allowed borrowers to deposit coins which could be staked, and then would take the staking rewards, sell them for UST and pay the depositors with that UST. In this way, they turned the coins from trapped collateral to interest-bearing collateral, so long as the staking rewards were non-zero. Thus, Anchor staked the collateral to earn yield and charged its users for loans; the returns from both staking and loans were paid through to depositors.

In a closed economic system, Anchor would have represented a source of sustainable, fundamental yield for the Terra blockchain, a sort of LIBOR-equivalent lending rate against secured collateral. However, in order to accelerate the adoption of UST, Terraform Labs also funded a yield reserve above and beyond what Anchor protocol paid with its organic yield in order to encourage users to mint UST.

That yield was ~20% until recently.

The Endgame

Twenty percent was significantly above most of the lending/borrowing yields that are available on-chain. Terraform Labs’ subsidy led to Anchor’s accrual of $14B of UST deposits, which had to be made in UST. As Anchor’s UST deposits grew, so did the market cap of UST and the value of LUNA tokens, which were burned each time UST was minted. LUNA’s rising value increased attention on Terra, exacerbating the cycle.

However, the yield reserve became a problem. Deposits increased much faster than borrowing and the cost of maintaining a 20% yield on $14B of deposits was rapidly approaching $1B per year.8 A collection of significant holders of the ANC token, the governance token of Anchor Protocol, put forward several proposals to restructure Anchor in order to reduce the yield, and the community passed a proposal via on-chain governance voting to simply monotonically reduce the yield over time if the base economic yield was not sufficient.

When the Anchor yield began dropping, deposits were removed from the protocol. As deposits were removed, UST either needed to be destroyed via the arbitrage mechanism or exchanged for other stablecoins. The latter appeared to be the preferred method for many users, but this also caused the depletion of the stablecoin liquidity pool on Curve, a place where the inventory of stablecoins that can be swapped for each other is kept, as UST (which was supposed to be 25% of the pool) rapidly surged to over 50% of total assets. This created a supply and demand imbalance in the Curve stablecoin pool, where stablecoins usually trade for about $1, because fewer people wanted UST and more people wanted other tokens, such as reserve-backed stablecoins. The importance of this is that Curve itself is the most commonly used platform for exchanging stablecoins in DeFi, and is a protocol that many other protocols use to build on top of. This means that when a pool on Curve is compromised, there are many downstream implications, as well as the depletion of the primary source of liquidity in DeFi markets for a stablecoin. This led to UST losing its peg, trading below $1, and the arbitrage mechanism kicking in.

At the time of Terra’s collapse, to theoretically prevent a complete unwind of the chain in disorderly fashion, the blockchain had a $150mm per day limit on the amount of arbitrage that could be conducted. This limit was quickly hit on May 9, 2022,9 and UST continued to de-peg in the downward direction, which meant that additional LUNA needed to be minted in subsequent days in order to restore the peg. Market knowledge of this meant that LUNA holders began dumping their LUNA, which put massive downward pressure on LUNA itself.10 While the mechanism to prevent a downward spiral can limit on-chain activity, it cannot limit actual selling on crypto exchanges. The line did not hold.

UST ultimately succumbed to the same flaw as the algorithmic stablecoins that preceded it: the arbitrage mechanism for peg stability works only if there is adequate demand for the balancing coin. With a limit on the amount of arbitrage and LUNA in freefall, UST began to drop. As this cycle began, the market rushed to sell both LUNA and UST, rapidly increasing the speed of the decline. Without a buyer of last resort, there was no way to regain the peg.

The end result is that as of May 12, 2022, when the Terra blockchain was halted, Anchor Protocol has only $2.124B of deposits remaining, only $147mm borrowed, and UST itself is trading well below the peg.

Early Conclusions

While we are still in the early days of understanding what went wrong with UST, there are several key lessons that can be learned from the demise of the stability of the algorithmic coin.

First, fiat stablecoins with regulated reserves are very different. When there is a transparent, liquid, complete pool of assets behind a coin, a run is functionally not possible. If a stablecoin were collateralized not by an algorithmic pairing, but by a bankruptcy remote trust filled with only very short term US Treasury Bills, even if 100% of coin holders redeem their coins, these holders will be completely made whole on their principal with no losses due to the redemption event. Notably, USDP and BUSD, which are both regulated stablecoins, retained their peg over the last few days throughout the volatility. Even unregulated reserve-backed stablecoins outperformed UST, validating that the path to stability is through reserves, but ideally, through regulated, transparent and non-credit exposed reserves.

Second, algorithmic stablecoins are fundamentally unstable, at least as of yet. Each one designed has ultimately been hardwired to self-destruct. UST now joins a legion of predecessors, including IRON and Basis, to collapse after the recursive downward price spiral kicks off that is by definition, unrecoverable.12 The common characteristic is that these collapses are both violent and rapid. As a result, at least until a design is created that proves fundamentally stable over a long period of time, such coins should not be used without a full understanding of the risks, and certainly not for basic financial functions like payments, savings or lending. An algorithmic coin is not a stablecoin; it is a highly speculative economic experiment.

Third, there is a need for comprehensive regulation of stablecoins – not just around structure, reserves, redemption rights, and stability, but also around disclosures and representations to the holders and users of these coins.

Paxos, as the issuer of both USDP and BUSD, holds only cash, US Treasury Bills, and reverse repo secured by US Treasuries13 behind USDP and BUSD in order to have non-credit exposed assets to meet even the catastrophic scenario of a full redemption of these coins. The reserves are held in a bankruptcy remote trust overseen by the New York Department of Financial Services, which has been successfully regulating stablecoins since 2018. There are clear redemption rights for all the holders of the coins. Attestations are published on a regular basis as to the assets backing these coins.14

Proper regulation and true stablecoins already exist, and need broader adoption to prevent another event that wipes out tens of billions of dollars of value. Much of which, in this case, may have been held by retail investors.

Paxos, as a regulation-focused crypto company committed to increasing trust and stability in the crypto markets, stands ready to help in these efforts.

The content of this blog post was prepared for informational purposes only and does not represent investment advice. For more information or to get in touch with Paxos, reach out to press@paxos.com.

Related News