Depegging: A History Lesson - Part 1
In which we need to brace, it's going to be a bumpy ride.
Stable Sis
1/4/20264 min read
With the recent conviction of Do Kwon, Terra's founder, I thought it timely to do a deep dive on an egregious case of things going wrong with stablecoins.
I wrote in my previous post about the three main types of stablecoins and TerraUSD as an example of what can go wrong with algorithmic stablecoins. I would argue that algorithmic stablecoins rely on the outward belief that the market is self correcting via arbitrage and therefore volatility will be dealt with by rational investors. There is however an implicit belief that all investors at the end of the day have to agree that the coin is worth something, ideally something in the region of the peg. And there is nothing to sustain this belief but belief itself. Remember, a true algorithmic stablecoin is not backed by any asset, traditional or crypto.
In his letter to the judge responsible for his case, Do Kwon is aware of this problem and posits that algorithmic stablecoins can indeed prove stable if there is an actual use case for them, an ecosystem of real economic activity where they can be used as currency. In my opinion, that same mechanism of belief applies to that ecosystem. All participants need to agree that real economic activity is occurring, with a value that can be measured in the chosen stablecoin. It is a beautiful idea and maybe Do Kwon is on to something, but building that kind of trust takes time and patience. Maybe one day we will all be more comfortable with stablecoins and this could truly happen, but we're simply not there now.
Let's start with the facts. Terra was founded in 2018 by Do Kwon and Daniel Shin, on the premise we just discussed. Like Ethereum, it was built as a smart contract blockchain and its native cryptocurrency was called LUNA. Demand for LUNA however, was sluggish (as you can see in the chart below) so, in an attempt to boost demand, the founders decided to launch an algorithimic stablecoin, UST, which was pegged to the dollar. At any point in time, one unit of UST could be traded for 1$ worth of LUNA. The peg therefore could be maintained by all the traders willing to exploit arbitrage opportunities.
For a while, things were ticking along nicely and trading volume steadily grew. Then came May 2021.
May 2021 was a dark month for cryptocurrencies in general. Musk decided to stop accepting payments in Bitcoins and the Chinese government banned the use of cryptocurrencies by businesses and financial institutions. Bitcoin lost almost 40% of its value, Ethereum lost almost 50%. Terra was also put to the test. A single seller dumped 88M UST at once. At the volume at which UST was trading at that point in time, this alone would have been a significant shock to the peg. At the same time however, a DDoS attack on Terra's infrastructure made it impossible for the arbitrageurs to step in and rescue the peg. As UST started trading at 0.95 (0.90 according to Do Kwon's account) the peg was effectively lost.
Do Kwon and the engineers hunkered down to repair the infrastructure. The traders started trading again. On May 26th 2021 the peg was restored. It had taken a week, but Terra had passed the test. Crypto enthusiasts around the world rejoiced. Here was proof that the algorithmic backing had worked and that it was indeed possible to have a stablecoin without any kind of collateral asset. And to satisfy the sceptics, the Luna Foundation Guard was set up to hold BitCoins and therefore fight off future depegging crises.
Do Kwon however, was keeping a secret. In May 2019, Jump Trading (a trading firm) had approached him and offered help in managing liquidity and depegging risks. They had size and credibility, had been successful with other cryptocurrencies and did not charge a fee or require Terra to put up capital. Instead, they "only" asked for options to buy Luna at various prices. Of course, as the price of Luna grew, so did the value of those options. The only ask Jump Trading had, was that their involvement should be kept secret.
During the May 2021 crisis, Jump Trading had stepped in and purchased enough UST to halt the downfall and start the recovery. Terra had not after all passed the test. But none of this was made public and so, once again, things started ticking along nicely.
In hindsight, it makes sense as to why they would want to keep quiet about their dealings with Terra. If the illusion of the only working algorithmic stablecoin could be preserved intact, then they would have preferential access to an asset whose value would just keep on growing. And, at a certain size, the illusion might just become reality and the volume of transactions large enough to maintain the peg at all times. This belief was further cemented by Terra surviving another depegging event in February 2022 without the help of Jump Trading and relying on the algorithmic backing alone. It seemed that Do Kwon's vision would become reality and Jump Trading would profit immensely. Everyone would win.
For better or for worse, this is not how things turned out. Here is my postmortem on the fate of Terra.
Until next time,
Stable Sis