Insider Insights May 2022 Issue

TerraUSD and Luna Stablecoin Ecosystem Crash: What’s Next?

Earlier this month, the price of the Luna digital asset crashed down to a fraction of a cent from a high over $77 over the span of a few short days. The asset had previously weathered a few bumps in the road and appeared to have a healthy ecosystem behind it, so the flash crash caught investors and onlookers off guard. The community is already conducting a sort of post-mortem analysis to determine what happened and how to potentially prevent it with other assets going forward.

The mechanics behind the crash

Although the story is still developing, the most plausible story revolves around the 20% APY guaranteed by the Anchor protocol. The prospect of such a high, guaranteed, and fixed return should have been concerning on its face – staking rewards are by no means uncommon in digital assets, but they are usually subject to change based on economic factors or coin dynamics. Where LUNA’s story differed is that it demonstrated surprising resilience when faced with adversity. It had previously lost 81% of its value in May 2021, only to later rebound. It again fell to $47 in January 2022, only to jump back to over $100 by April. Had it been a scheme, it would not have recovered, as scams generally do not persist past such a vicious shock; the fact that Luna could take a hit or two engendered a level of authenticity to the asset.

It turned out, however, that deposits in the LUNA and TerraUSD ecosystem were sufficient to weather the storm, until they suddenly weren’t. When the market capitalization of UST surpassed LUNA’s, that meant that mathematically there was a bag holder somewhere, since someone, somewhere would not be able to cash out the value of the coin if everyone decided to do so. The greater the difference between the two, the more bag holders there were, which created a panic as holders continued to attempt to exit. The Luna Foundation Guard, seeing the drop, injected over $200 million to attempt to resolve the situation, which it did for a time – but it appears to have only delayed the inevitable. As the situation deteriorated, UST drifted further and further from its $1 USD peg. As of this writing, it has hovered between $0.17 and $0.20 for a few days, while LUNA is only worth a hundredth of a cent with nearly imperceptible movement. During this process, the chain was also shut down several times to prevent governance attacks, which has also not engendered trust in the asset.

It’s been suggested that the root cause of the crash may have simply been a case of easy come, easy go. The ecosystem enticed investors with a staggering return rate that stood head and shoulders above other coins, but in the end, that’s all it offered. There was no interest in the asset ecosystem beyond that very specific aspect of it, and when it was feared that there would be no further returns, the asset collapsed as there was nothing further it could offer investors. Other assets such as Bitcoin, although they have experienced massive swings and high volatility in the past (this last month being no exception) the fact that there has been a community and ecosystem built up over the years has prevented such a catastrophic drop. When LUNA had no such fallback point, there was simply nowhere else to go.

What this means for stablecoins as a whole

As a result of the drop, the SEC has already opened a probe. LUNA’s founder Do Kwon had already been on their radar, having previously been served papers by the SEC in September 2021 prior to Kwon giving a presentation at the Messari Mainnet Conference. In February, Kwon was again ordered to comply with the subpoena. Although it was previously unclear whether the SEC had jurisdiction over Kwon, the crash has tilted the situation closer in the SEC’s favor. US Treasury Secretary Janet Yellen cited the situation as evidence of a potential threat to financial stability and described it as similar to a bank run. Previously, the US Treasury Department had already asked Congress to address concerns over what they described as “key gaps” in the functionality of stablecoins, and the LUNA situation is likely to bring renewed interest.

Other stablecoins such as Tether and Circle are collateralized, meaning that deposits are backed up by USD or some other kind of debt instrument. UST, on the other hand, is algorithmic and its peg was maintained by LUNA. If one asset changes in price, it creates an arbitrage opportunity for the other, which theoretically should keep the price where it needs to be. However, it appears that this can only be taken so far. A combination of panic selling, uncertainty in the solvency of the coin, and low Bitcoin price leading to lower potential reserves sent the coin into a tailspin, from which it is not clear it will recover – not to mention the potential chilling effect the event may have on other stablecoins, especially algorithmic ones. It’s reminiscent of bad actors in the past publishing uncollateralized ICOs (initial coin offerings) in years prior which led to them developing a poor reputation, eventually giving way to STOs (security token offerings) which represented a stake in real world assets.

Digital assets are known for their volatility in general, but the concept of stablecoins is that they need to be just that – stable, and if adverse conditions can swing a coin’s price, even an unlikely combination of several factors, then that does not bode well for other algorithmic stablecoins unless they take notes to not fall prey to the same concerns.

Conclusion

The fall of LUNA may be a costly lesson that although digital assets are entirely virtual, they still need to be tied to real assets, people, and communities in the real world. The system promised staggering, guaranteed staking returns that could only be provided so long as the system was in place, rather than relying on market fundamentals and a sobering acknowledgement of the risk involved in investment.

If you have questions about our fund or would like to be sent investor documents, you can contact our investor relations department at contact@varys.capital.

Regards,

Darius Askaripour
Managing Partner

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