What happened UST, and was it an attack?
- A breakdown from start to finish on what exactly happened UST, the $18 billion stablecoin that collapsed today
- Why this is a very dark day for crypto, regardless of whether you own UST or Luna
- What the future holds for UST, Luna and crypto as a whole
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This isn’t a very fun article to write. An entire ecosystem has blown up, and many lives have been destroyed. NFT projects, De-Fi apps, payment processing apps, Mirror, Anchor, Kash – these are just a few of the projects built on this once-thriving ecosystem.
Even if you don’t own a dollar of either Luna or UST, this is a dark day for cryptocurrency as a whole. Regulators won’t take kindly to all this wealth evaporating so quickly. As I said, lives have been destroyed, and this won’t facilitate crypto-friendly laws getting any closer.
I have friends who were heavily invested, and it’s sad seeing what’s happened. You can say they should have seen it coming; maybe you have a point. Then again, black swans always catch you unawares, otherwise they’d just be swans, wouldn’t they? But whether it was predictable or not, it doesn’t make it any less sad, nor devastating for the community at large.
But what actually happened? Let’s dive in from start to finish.
As I write this, Luna is trading at $1.16, down 99% from its all-time high. UST is still flailing around, trading at 68 cents. While the numbers may be different by the time you lay eyes on this piece (I have already edited them six times throughout the course of writing this), at this stage it doesn’t really matter.
There is a lot of speculation going around about what led to the run-on-the-bank style collapse suffered by UST. I normally steer clear of conspiracy theories, but the scale of the destruction here, and the unprecedented nature of it – Luna plummeting from $42 billion and UST from $18 billion – made me determined to dig into what happened and assess all scenarios.
I believe there is a definite possibility this was a coordinated attack, for reasons I will disclose below. By who? I have no idea, and right now I don’t particularly care. There are many rumours going around on Twitter, but I’m not eager to dive into that, as I don’t know.
Besides, the “how” is much more interesting than the “who”.
The entire UST algorithmic mechanism is very complex, so I’ll try explaining the events of the last couple of days in as simple and concise a manner as possible.
UST is the stablecoin that is collateralised by Luna. Selling 1 UST will always enable you to mint $1 of Luna, and vice-versa. In such a way, the popularity of UST fuels Luna, which explains Luna’s meteoric price rise as UST mushroomed to an $18 billion market cap and a top 10 cryptocurrency. Hit “Play Timeline” on the below graph to see a graphical demonstration of this relationship from March 2021 to present.
Luna, however, is not collateralised by anything. Therefore, the question doubters always asked was the following:
What happens if there is a large quantity of UST sold?
In that scenario, every dollar of UST sold mints a new Luna tokens, which makes the price of Luna fall heavily. Which is how it’s meant to work. But if the selling pressure of UST is so much that Luna can’t absorb the volume, what happens then? Well, the peg has to give way. 99 cents. 98 cents. 97 cents. Then, people panic. They sell more UST. Which means the peg dips further. And on and on we go. It’s a run on the bank.
The Fatal Flaw
Earlier this year, Terra founder Do Kwon announced that Bitcoin would be used as collateral, so that in such scenarios as described above, Terra could intervene and sell these Bitcoin reserves to buy UST, hence propping the price back up until the $1 was restored. This was outlined to kick in when the peg dropped to 98 cents.
This is key, and it was a massive oversight by Terra. It doesn’t make much sense to collateralise an asset (UST) with a highly volatile asset (BTC). It makes even less sense when those two assets are correlated to each other.
Think about this – the stress test of the ecosystem was always going to come on a red day. So, on a day when Bitcoin is crashing, the plan was to sell this crashing Bitcoin to assuage the selling of UST and prop up the peg. Terra (via the LFG, who were in charge of the collateral) bought 37,000 bitcoins last Thursday, bringing their collateral kitty up to $3.5 billion. This means less than 20% of UST’s $18 billion market cap was collateralised.
However, given the Bitcoin holdings and plan were all public, the market knew what would happen. Once UST started losing its peg, it meant Terra would sell their Bitcoin to buy UST and restore the peg. With this massive sell order imminently hitting the market – remember, Terra is in the top 10 holders of Bitcoin – the price of Bitcoin then starts falling in anticipation of the large sales to buy back UST.
This obviously lowers the value of Terra’s collateral package, as Bitcoin tanks itself. Therefore, Terra’s ability to prop up the peg is restrained, because the market value of their collateral is falling. Their $3.5 billion and 20% collaterisation ratio soon became $2.6 billion and 14% collateral. This, of course, causes further fear and panic, further selling, and further fear. And on we go. That’s how you get the peg collapsing, contagion and mass meltdown.
A couple of things need to happen to trigger all this off inorganically, but they are not exactly difficult to accomplish. The first is that you need to create anxiety by pushing UST off its peg. That’s where the timing comes in.
The attack, if this was an attack, was made possible on April 1st when Do Kwon tweeted out the below.
The curve wars are complex, but in high-level terms, the above tweet is relevant because it meant that there would be lower liquidity in the decentralised UST pool (we are not talking about centralised exchanges here). Instead of $3 billion in the pool, there would be $350 million – which makes the capital required for an attack significantly less.
Also, a quick intervention. While this is far from guaranteed to be driven by an attack, and all be merely organic, the fact it all took place on the blockchain makes the numbers accurate. This is what happened – the only doubt is whether an actor triggered it or not. The fascinating thing about cryptocurrency is that the blockchain broadcasts everything live as it happens – and for Terra, as you will see, that was part of the problem.
Whoever the attacker is (if there is one at all) starts off by borrowing bitcoin. There was a popular story this was done via Gemini, but I spent nearly an hour digging on-chain to verify this before Gemini came out about five minutes after I finished to confirm it wasn’t true. Hah.
There were also rumours the attack was instigated by Citadel and BlackRock, however both firms have denied any involvement. But whoever the attacker is, if there is one, would have taken the following strategy. First, they borrow $1 billion of UST (using simple numbers). Because the liquidity in the pool is less for the above reasons, the attacker only needs to sell $350 million of UST to drain the pool of all liquidity (significantly more capital efficient than it otherwise would have been). And now we have the first concern over the peg.
The below graph shows this draining of $350 million liquidity out of the pool. Again, this part is complex, but the ins and out aren’t all that important, the bottom line that needs to be understood is that the liquidity was temporarily low, which allowed a $350 million sell order to drain the pool, whereas this normally would have required $3 billion.
Once the pool is drained, people worry, because there is no liquidity left.
This is why UST fell to 99 cents originally, where it teetered over the weekend.
Concern Turns to Panic
But it wasn’t yet a catastrophe – and this happened for two days or so. On Monday, once the UST hit 98 cents, Terra stepped up to restore the peg by selling their Bitcoin and purchasing UST. This, although he couldn’t have known it at the time, was Do Kwon walking right into the trap – if, that is, this was all a coordinated attack.
As LFG liquidates the Bitcoin, this pushes Bitcoin’s price down – helping the attacker’s short position. The attacker also still has $650 million left in UST (remember, there was only $350 million required to drain the decentralised pool). So now the attacker moves to centralised exchanges and starts unloading all the UST.
This was when the panic really kicked in. With the combination of this mass selling of UST and the public confirmation that Do Kwon had already stepped in to shore the peg up with the Bitcoin sales, the fact the peg was continuing to drop caused anxiety levels to rise.
By now, it’s mission accomplished really, as the rest takes care of itself. And that only required $1 billion in capital. More and more UST floods for the exit, and there’s simply no way to stop it. UST continues to be dumped, with the corresponding Luna minted, and hence Luna’s price deflates too.
Chains started becoming congested as people ran for the exits. Traders who took out loans on Anchor at liquidation prices as low as $30 Luna got margin called (remember, Luna was at $85 less than a week ago, and even on Monday was still at $60, so this liquidation level would have seemed very safe for borrowers). With transactions not going through amid the congestion, even those with capital to deploy to satisfy margin calls were liquidated, and the cascading effects were at this point unstoppable. The confidence was gone.
Binance then locked UST when the peg hit 60 cents, which was the final straw.
So, why didn’t it hit $0? Well, there was still a chance a bailout could be agreed upon overnight. The normally active Do Kwon had been silent over the course of 24 hours – a move which certainly didn’t pacify the panic – but eventually tweeted that a plan was to be put in place.
As Tuesday evening closed EST time, there was hope an agreement would be reached, with rumours such as the below circulating. After all, if the peg could be restored, UST could be moved to a collateralised model and theoretically survive. Luna, at this point, was trading at around $18.
When I woke up at 6 AM this morning (GMT -6), Do Kwon had released a thread 45 minutes before me. I checked the price before I read it, and that was all I needed to know as to whether a bailout had been agreed. Luna was at $4.
There was no option at this point, as Kwon could not secure a bailout. If the peg was to be restored, Luna had to absorb all the selling pressure of the UST that still wanted to be sold – and that was a lot.
In essence, he was forced to throw Luna under the bus in the hopes of saving UST. Given the confidence in the uncollaterised model was well and truly gone now, any hope of UST being trustworthy going forward was zero unless collateralised. Therefore, as part of the same thread, he announced the intention to abandon the Luna arbitrage model and swap to a fully collateralised stablecoin.
That brings us to where we are now. In truth, it doesn’t really matter whether this was a malevolent and calculated attack or whether it was organically driven. Looking at the on-chain data, the timing coinciding with the lower liquidity on Curve, and the time delay between the original small de-peg over the weekend and the meltdown yesterday/today, it’s tempting to believe it was indeed pre-meditated.
If it was an attack, it is the exact same principle as the famous trade George Soros pulled off in 1992, when he bankrupted the Bank of England. Soros realised that inflation was significantly higher in Britain than in Germany, making a peg of the British pound to the German Deutschmark unworkable.
High interest rates were set by the British in order to attract more people to the pound, although these were unsustainable – much in the same way that Terra’s Bitcoin funds were not sustainable to protect its peg. Soros shorted the British pound so heavily that it was forced to abandon its peg to the German Deutschmark.
While Soros pocketed $1 billion in a single day from the trade, the pound rebounded stronger. Free from the peg, interest rates could be reduced and inflation curtailed.
While the story is the same here for Terra, the last part – the rebound – isn’t.
Luna has a very real chance of going to literal zero, depending on what happens with the UST peg. Should the UST peg be brought back, it will also be moving to a collateralised model, as outlined by Kwon above. In this situation, it’s unclear what role Luna would play, even if it doesn’t go to zero. Without the automatic minting mechanism to algorithmically peg UST to $1, we don’t know right now what role Luna would even have, assuming it does survive.
But regardless of whether this was a Soros-esque attack, the system was shown to be inherently flawed, and it collapsed. The cause is not relevant, we are here now one way or another. And for one last time, I really don’t know for certain whether it was an attack or not – but the potential to do it so easily does neatly show how inherently flawed the system was, regardless.
Is there any way forward? Well, emotions are high and markets are being driven by fear rather than fundamentals now, and there isn’t much precedent to base any forecasts off here. My gut feel is the peg does rebound to $1, at least in the short-term. But I don’t see any way forward for Luna. Of course, I say this with almost zero conviction, and I wouldn’t be going near either asset with a cent right now – it would just be gambling.
But the ramifications go beyond just Terra. This is an $18 billion stablecoin that has disappeared. You can’t have that much money go poof without contagion effects showing up elsewhere. For fear of repeating myself too much, my below tweet conveys my feelings here.
It’s a bloodbath worse than possibly anything we have seen before in crypto. How many start-ups had funds parked in Anchor, pocketing the 19.5% APY? How many crypto funds were exposed? What about custodial lending services? The first thing I did when I woke up this morning was to remove all my bitcoin from custodial services– the “not your keys, not your coins” mantra has never been so important. I’ll sit on the sidelines until the madness washes over, and until I get an iota of conviction back.
As I said in the intro, this is a dark day for crypto. People have lost livelihoods, hundreds of platforms have gone belly up, and years of building vanished. College funds, life savings, leveraged gambles – there is a lot of pain out there. Regulators are watching, and this is undoubtedly a step back.
Obviously, it is also a failure of the decentralised and uncollaterised stablecoin. A tremendous financial experiment has gone haywire and taken a big chunk of the market with it.
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