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The collapse of UST - $84 Million Leveraging on a $40 Billion Financial Empire
Thu, 12 May 2022 07:29:43 GMT
Who could have predicted how the second largest public blockchain with over $20 billion TVL, collapsed like Lehman Brothers in just the span of 2 days

In the year 1997, billionaire George Soros and his other hedge fund managers executed a well-coordinated manipulation of currencies in an attempt to destabilize the ASEAN economies. By selling a large amount of Thai Baht, it quickly exhausted the Bank of Thailand's $30 billion foreign exchange reserves, eventually forcing them to implement a floating exchange rate system. This further pushed the Southeast Asian countries into the depths of a financial crisis.

Fast forward to 2008, where we were faced with yet again another financial crisis that almost destroyed the modern financial system. Due to the large exposure of bad debts due to toxic collateralized debt obligations (CDO), Lehman Brothers' net liabilities far exceeded the company's market value. As a result, they were forced to file for bankruptcy in the Federal District Court of the Southern District of New York.

Anyone with basic economic knowledge would have been aware of these events, and they have been labeled as historical financial crises that people use as case studies. But, who would have thought that in just a span of 10 years, such crisis would reenact again, this time in the crypto markets. Interestingly, due to the transparency that the blockchain offers, we are all able to witness this "live".

On 10th May 2022, Terra's algorithmic stablecoin UST was faced with a debt crisis, resulting in a severe depeg from the dollar, falling as low as $0.60. Within the span of 2 days, the second largest blockchain with over $20 billion TVL, collapsed just like the Lehman Brothers and Thai Baht.

Margin Call: Death Spiral to UST

Terra, being the second largest public blockchain within the crypto markets, had its fair share of controversy. On one hand, the minting mechanism of LUNA-UST has allowed Terra to successfully popularized its algorithmic stablecoin UST onto the entire crypto market, which swiftly boosted LUNA's price and market value. On the other hand, Anchor Protocol has been widely seen as an "advertising machine" for UST, leading many to conclude that this will be an unsustainable Ponzi scheme.

For a long time, there has been a clear dichotomy between LUNA supporters and skeptics. Supporters are known as "Lunatics", and they are all over Twitter refuting (sometimes attacking) Luna critics. Skeptics, on the other hand, believe strongly that this is a Ponzi scheme, waiting for the day everything comes crashing down. It is hard for speculators to ignore such a "tense" environment, while hedge fund managers are constantly observing for any industry movements, waiting for their best opportunity to strike.

Opportunity finally arrived after the Federal Reserve announced an increase in interest rates by 50 basis points. Throughout May, the Nasdaq continues to decline, and the markets do not have a positive outlook on the economy. The price of Bitcoin consistently declines about 10%, fear is looming across the entire cryptocurrency market. Luna Foundation Guard (LFG), Terra's own nonprofit organization, announced that they will be making some adjustments to their UST-3Crv liquidity pool on 8th May, in preparation for a much stronger 4Crv pool.

These conditions created the perfect opportunity for the hedge funds to strike. On the night of May 8th, these hedge funds began to execute their takeover plan.

Stage One: Manipulate the UST-3Crv liquidity pool balance

On the morning of 8th May, LFG withdrew $150M of UST from the UST-3Crv pool in order to prepare for the 4Crv pool. At that moment, there is only $700M left in the UST-3Crv pool, and it only requires $300M to dry up UST's liquidity.

Just 10 minutes later, a new address was seen transferring $85M UST out, which severely affected the 3Crv pool balance.

In order to maintain UST-3Crv liquidity pool balance, LFG subsequently withdrew $100M UST.

By then, rumours were spreading across Twitter, speculating that it was all LFG's own doings. Terra founder Do Kwon swiftly responded to it.

Not long after, multiple whale wallets are seen selling off UST on Binance, and they are all million-dollar transactions.

UST started to lose its peg after these massive dumps. Jump Trading (UST market maker) sold large amounts of ETH for UST, in attempts to stabilize UST's peg.

As of now, the address sold over 50,000ETH in order to stabilize UST's peg, and only had less than 13 ETH remaining.

Until now, the attack was mainly on the UST-3Crv pool, which involved up to $300M. If the 4Crv pool with $4B was built before this, the aforementioned attack would not work.

Stage Two: Massive withdrawals from Anchor due to FUD

Due to the depegging incident that happened in the early morning, fear, uncertainty and doubt (FUD) quickly spread across UST and Luna holders. Subsequently, large amounts of UST were withdrawn from Anchor, further worsening UST's selling pressure.

At the same time, LFG has announced to "loan" $750M worth of BTC to help protect UST's peg.

According to Do Kwon, UST that is above $0.95 is not considered depegged, hence no significant action is required.

This explains why UST did not return to its $1 peg ever since 8th May.

As UST was not able to regain its dollar peg, it caused a lot of FUD within the markets, something that LFG failed to realize. As more people withdrew UST from Anchor, UST's peg dipped below $0.95. LFG was forced to tap on their Bitcoin reserves, as seen from Do Kwon's tweet: "Deploying more capital"

Subsequently, an address starting with "0x559" started to absorb UST from the market, which amounted close to $200M.

This allowed the UST-3Crv pool to quickly regain balance. However, Bitcoin's price decline led to the fall in price of other coins as well. Market sentiments continued to worsen, resulting in LUNA's large-scale liquidation and increased selling pressure for UST. UST-3Crv pool quickly lost its balance as well.

On the morning of 10th May, Jump Trading and LFG might have realized the problem and stopped selling its Bitcoin reserves to stabilize the peg. This resulted in UST plummeting all the way to $0.60. Although the price rebounded a while later, the proportion of the UST-3Crv pool remained severely unbalanced (91.37%/8.63%).

Stage Three: Backstage Deals, Rumours of Institutional Bailout

After a terrifying 2 hour death spiral on UST, rumours started to emerge, stating that Jump, Alameda and other institutions will provide $2B to bail out UST. Following that, an address starting with "0x6c" received a $2B deposit, but nothing else happened, leading many to believe that it had nothing to do with bailing out UST.

Furthermore, Binance seemingly participated in defending UST. According to Uncommon Core's podcast host Hasu, Binance forcefully set a threshold price of $0.70 for UST, which disallowed users to place any orders below $0.70 for a period of time.

This morning, more LFG-financing related news emerged. According to sources, LFG is seeking help from institutions in hopes of raising $1B to support UST. According to Larry, a researcher at The Block, as of now, Jump Trading, Celsius and Jane Street have agreed to the financing, pledging about $700M. Alameda Research has not agreed yet. The institutions are asking to accumulate LUNA at a 50% discount, lock them for a year, and release them linearly every month after the vesting period. However, Larry emphasized that these are all unconfirmed and are subject to change.

Even though the entire narrative of UST depegging may be speculative, we have found some reliable information about UST. On the morning of 10th May, famous investor and Real Vision's founder Raoul Pal had an interview with Terra's founder Do Kwon about UST's depeg. Even though the dialogue has not been broadcast, Raoul revealed some details of the incident in a subsequent interview with Bankless.

"Simple, UST depegs, as UST's market maker, Jump Trading was forced to sell their ETH to buy UST, and LFG had to liquidate their Bitcoin reserves". Raoul briefly explained the entire saga, and added, "This is the very classic Margin Call, as though someone tapped Luna's shoulder and demanded their collateral. This happens every day in the world of traditional finance."

Indeed, the amount that triggered the UST death spiral is no more than $300M, and the scale at which it happened was only a few billion dollars, which is nothing compared to traditional finance. Interestingly, this happened in full view of the public, a phenomenon that is extremely rare to witness for the general public. Thanks to blockchain technology, we are able to witness explicitly how the first large-scale financial crisis in the crypto markets went down.

This is not the first time UST has depegged and underwent a death spiral. During 19th May last year, UST had also lost its dollar peg, falling to $0.85. After some help from LFG, LUNA and UST were able to continue developing. Since then, in order to prevent such events from happening again, LFG has made some changes, which includes revamping UST's endorsement mechanism.

As a matter of fact, purchasing BTC and other L1 tokens as a form of endorsement is not necessarily a wrong decision. However, this requires some time for the new mechanism to achieve its full effect. Sadly, the markets did not give Do Kwon and LUNA maximalists enough time to redeem themselves, resulting in this catastrophe.

Incoming Regulation?

As a seasoned DeFi investor, one should know that this depeg will not just affect the Terra ecosystem. Similar to Lehman's bankruptcy, Luna's collapse may possibly affect the entire cryptocurrency market. However, in Raoul's view, the worst impact from this depegging incident may come from the regulatory side. The moves pulled by the hedge funds may attract regulators up their tail.

As we may be aware, countries around the world have been trying to popularize their own digital currencies (CBDC). UST, which was once labeled for its "stability", undoubtedly gave regulators the perfect chance to start clamping down hard on us. Currently, people are much less worried about whether investor confidence can recover, but rather more on regulation for stablecoins. Many discussions about regulations have been spreading around Twitter, causing many concerns.

Sure enough, regulators have emerged to discuss this issue. According to news from Blockbeats, at the meeting on Capitol Hill on 10th May, US Treasury Secretary Yellen pushes for the regulation of stablecoins in the cryptocurrency market. Yellen believes that legislation for stablecoins will be imminent. "This field is growing rapidly and brings huge risks. Terra UST has experienced a sharp decline today."

Undoubtedly, the collapse of UST has cast a regulatory shadow over stablecoins. One must wonder, will regulators launch a regulatory clamp down on stablecoins? Will we lose our freedom in the cryptocurrency markets in the future?