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DeFi and Credit Risk

The Latest:

  • UST dropped as low as $0.65 on Monday, suggesting a potential collapse of the market’s leading algorithmic stablecoin.
  • LUNA, UST’s shock absorber, dropped 50% to $30.
  • Luna Foundation Guard, the entity in charge of maintaining the stablecoin’s peg, drained its $1.5 billion bitcoin reserve and bought $850 million more in BTC in a bid to defend UST’s peg.
  • The move may have created sell pressure contributing to bitcoin’s 10% price dip on Monday.
According to the most current price estimates from CoinMarketCap, algorithmic stablecoin UST lost its $1 peg for the second time in three days on Monday, sliding as low as $0.65. According to CoinMarketCap, the price of LUNA, UST's sibling token, has plunged 45 percent to $33 in the last 24 hours as a result of the "depegging."


The Luna Foundation Guard (LFG), the custodian of Terra's bitcoin reserves, purchased and promptly deployed 28,205 bitcoin in an attempt to protect the peg by purchasing UST and providing liquidity on exchanges. That move corresponded with a minor price recovery for UST, which rose from lows in the $0.65 level to $0.78 at press time.

As bitcoin fell 10% on Monday, supporters and critics alike wondered how much LFG's efforts to save bitcoin aggravated a sell-off that sent BTC to its lowest price since July 2021.

On Monday, while Terra supporters continued to express optimism, a gathering of longstanding critics chanted, "I told you so." Some even compared Terra to IRON Finance, a stablecoin that plummeted to zero last year in what was dubbed "crypto's first large-scale bank run."

"There are still adequate reserves to sustain the peg," Jose Maria Macedo, a member of the LFG's council, told CoinDesk earlier in the day, as UST's depeg became apparent.

Using game theory and a set of blockchain-based mint and burn rules, UST, an algorithmic stablecoin, collaborates with LUNA to maintain a $1 price. In an ideal scenario, these mechanisms would ensure that traders may always exchange $1 worth of UST for $1 worth of LUNA, which has a floating price and is intended to act as a buffer against UST price volatility.

With their fully collateralized replies to the digital dollar, centralized stablecoins like USDC and Tether form the backbone of decentralized finance (DeFi), but Terra's "decentralized" UST stablecoin has been nibbling at their heels as of late, with a market valuation of over $18 billion.

Terra claims that their algorithmic stablecoin will decentralize power and end failing monetary regimes. Skeptics claim that the entire system is a ponzi scam fueled by memes, phony fundamentals, and whales.

A UST failure would reverberate across the DeFi business, raising red flags for authorities who see regular investors carrying the bag.

What the future will look like

Major UST sell-offs from a Terra whale and precipitous withdrawals from UST's Anchor money market drove UST as low as $0.985 on Saturday, indicating that trouble was building for Terra.

Last Friday, 75 percent of the circulating UST was placed in Anchor, which had previously enticed investors with yearly returns of 20 percent.

Anchor's UST deposits plummeted from $14 billion to about $7 billion when the price of UST plummeted by 72 hours.

The stablecoin's substantial dependence on Anchor has long sparked controversy among supporters and opponents, who claim that Terraform Labs (Terra's developers) and its big-money sponsors, such as Jump Crypto and Three Arrows Capital, artificially inflate Anchor's yields.

Anchor would have been obliged to lower returns over time, opponents claim, to the point where users would no longer have any reason to lock up UST with the platform. In a world where the UST had few other applications, such a situation would have been disastrous for the currency.

To assuage these and other concerns, Terraform Labs CEO Do Kwon went on a large bitcoin buying binge in order to construct a type of UST partial reserve. The newly established LFG received the bitcoin reserves, which have no direct relationship to the smart contracts that underpin Terra's UST stablecoin.

LFG stated on Monday that it will loan reserves to professional market makers for the first time in a bid to protect UST's peg.

The reserve reserves, which were increased by $850 million on Monday, have been utilized to protect UST's peg on Binance and Curve.

While LFG council member Macedo told CoinDesk that the BTC reserves would be sufficient to preserve the UST peg, not everyone is convinced.

"[Terra] barely bought itself a day with their $750 million peg defensive move," says Kevin Galois, a hedge fund manager and Terra critic.

"They can either let LUNA bleed out the maximum convertible amount every day or recapitalize the UST debt for pennies on the dollar at this moment." "So either haircut the UST holders or let the LUNA holders lose a lot of money," Galois wrote to CoinDesk.

The fact that Luna's market cap has gone below that of UST is perhaps the most significant result of Monday's price movement. This might undermine the whole stabilization mechanism of UST, which is based on the premise that 1 UST can always be exchanged for $1 of LUNA.

If UST is more valuable than LUNA, Terra might face bankruptcy if a bank run occurs.

What people have to say

Do Kwon, Terra's Korea-based founder, was unusually quiet on Monday: his lone tweet was "deploying more funds — steady boys."

In the midst of Kwon's quiet, some Terra supporters, dubbed "LUNAtics," appeared to be debating the likelihood of a Terra collapse. The price drops, according to one member of the 31,000-strong Discord group, are a "huge obstacle" that prevents onlookers from adopting "the fundamental notion of Terra + UST: decentralization."

Terra's Discord administrators had set "slow mode" to one hour by 9:00 PM New York time to keep the LUNAtics calm.

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