Market Commentary | UST De-pegging
10.05.2022
www.q9capital.com
For the First Time in a While My HODLer Friends Felt Pain Due to Forced Selling
Over the weekend, Terra UST, the third largest stablecoin (after USDT and USDC) lost its peg vs the dollar. This is very big news. The asset traded to more than -35% discount to USD, before rebounding (~10% discount to USD at the time of writing).
How UST’s peg works
The Terra ecosystem operates with two tokens: UST and LUNA.
UST is an algorithmic stablecoin designed to maintain a 1:1 peg with the US dollar, using LUNA as the governance token through algorithmic minting and burning mechanics… ie, it is not backed by the greenback or a physical asset. Its peg is derived through an algorithm.
An arbitrage opportunity is created when UST falls off its $1 peg. Traders can burn LUNA and create new UST when UST is priced over $1 and profit. When UST is below $1, UST gets burned and the minted LUNA gets sold to help stabilize the peg.
The stablecoin has seen a huge demand since November onwards with the market cap growing from $2.5bn to over $18bn. Most of that growth came via the Anchor protocol which was paying 20% APY to hold UST.
The Luna Foundation Guard (LFG) is also in charge of Anchor bootstrapping — ie, sell treasury LUNA and fill up the Anchor protocol reserve. An increase in UST supply will result in a decrease in LUNA supply. If the Luna price goes up, sell more Luna to fund the protocol reserve.
This idea got tested in January when it first lost its peg. Subsequently in February, Jump, Three Arrows Capital and others made a $1bn OTC deal investing in a BTC reserve for Terra’s UST. LFG accumulated more than 42.5k BTC as reserves to be used to defend the UST peg.
When the Levee Broke
Trouble began for UST after an $85mn transfer which came from the Terra blockchain through the Wormhole bridge to Ethereum, and was quickly sold on Curve on May 7th. Another $108mn in UST from the same Terra address was sent to the Binance exchange and sold, leading to the loss of the dollar peg.
Fear then gripped holders who were worried about a further price decline. This caused a run on the asset, causing its discount to widen. Around $3.5bn has been withdrawn from Anchor since the beginning of this event.
The market’s biggest concern is that one of the biggest Bitcoin buyers (LFG) will now become a big seller to defend the UST peg. Combined with thin liquidity (over weekend) and tough macro conditions that have already led to a sharp drop in the price of Bitcoin (and crypto).
A big faction of crypto participants have voiced their concern over the idea of using BTC to support the peg. So, this de-pegging event is not a black swan — the market has been considering this outcome for a while. We do not know how each institutional or retail investor priced in this tail risk.
Someone Needs to Do God’s Work
As a response LFG voted yesterday to loan out $750mn BTC and $750mn UST to large market makers in efforts to help sustain the peg.
The perfect outcome for LFG from here is that market makers are successful in getting the peg back at parity and increase the BTC reserves of LFG at a lower cost basis.
Who Paid for High Yields?
If the peg gets back to par, the biggest losers on this trade would be the retail and investors who lost 25 cents on the dollar during the bank run panic. Crypto protocols are complex, especially the ones belonging to the latest generation of products. Not every investor will do their homework.
For the record we at Q9 do not have any direct exposure to UST or product with UST as underlying asset. UST did not meet our risk parameters even after considering the staking rewards offering 20% APY (on Anchor protocol) that were (previously) considered to be a low risk strategy among many market participants. We work to provide our clients with innovative products with high standards in an effort to build crypto for everyone.
www.q9capital.com
