Instead, officials found themselves scrambling to improvise solutions, offering some $1.5 billion of cryptocurrency loans to maintain the peg and later reportedly scrambling to line up fresh capital to back the project. (A spokesperson for the project didn't immediately respond to a request for comment.)
As of late Tuesday, UST was changing hands below 80 cents.
“The reserves had reached its desired size, but the infrastructure to utilize the reserves was not in place,” Vetle Lunde, analyst at the Norway-based crypto research firm Arcane Research, said. “Add a bleeding market and poor weekend liquidity to the mix, and you've got yourself a great opportunity to attack.”
UST is the largest algorithmic stablecoin, with a market capitalization that topped $18 billion before losing its peg to the dollar during the weekend, falling to as low as 68 cents on Monday, and its implosion sent shockwaves through the crypto market.
To address those fears, Terraform Labs, the firm that developed the Terra blockchain, coordinated with other investors to create an organization called the Luna Foundation Guard and started to accumulate a reserve that would support UST’s peg in a crisis.
LFG went on a buying spree, filling up the reserve with about $3.5 billion worth of crypto assets and became one of the largest single bitcoin holders on the market – but without a working system in place to deploy the reserve if a crisis happened.
Under a proposal by Jump Trading, a trading firm and an investor in LFG, the reserve would work like this: If the UST price fell below 98 cents, traders could swap UST to bitcoin (and other cryptocurrencies in the reserve) at the price peg, creating demand for UST with an arbitrage incentive.
But the crisis happened before the system could be put in place.
Jose Maria Macedo, a council member of the Luna Foundation Guard, told CoinDesk the bitcoin swap mechanism was expected to be shipped by the end of next week by the developer team of Astroport, a token exchange built on the Terra blockchain.
Do Kwon, co-founder of Terra developer firm Terraform Labs, tweeted Monday that the testnet launch was a few weeks away.
There has been a lot of talk about the chokepoints of algorithmic stablecoins lately, with critics saying that they are inherently unstable in a market downturn, and vulnerable for market participants to exploit weak points in the design.
Sean Farrell, analyst at FundStrat, wrote in a report Tuesday that “we have ample reason to believe that the ‘run’ on UST was not a coincidence, but a deliberate exploit of UST’s (clearly fragile) architecture.”
According to Farrell, here is what led to the turmoil:
- Before any panic, LFG removed on Saturday approximately $250 million from the UST-3pool on the stablecoin exchange platform Curve in two transactions, reportedly preparing for the launch of the upcoming 4pool.
- The seller dumped the UST at a pace that exceeded marginal demand, creating a positive feedback loop that brought the price of UST down to 98 cents.
- LFG loaned $1.5 billion from the reserve to traders tasked to restore the peg, and almost succeeded in bringing UST back to $1.
- When traditional markets opened Monday and continued to sell off, the original short seller apparently continued with its market swaps on Curve, knowing that few buyers would want to step in to save the algorithmic stablecoin.
- Market makers started selling bitcoin to support UST, but then realized that it would only make things worse because falling prices were reducing the ammunition available to support the peg.
“It's reminiscent of [billionaire George] Soros' attack on the Bank of England in the 1990s, albeit attacking the UST peg is a far more low-hanging fruit for sufficiently capitalized entities to attack,” Arcane Research’s Lunde said. George Soros’s successful hedge fund bet against the British pound's exchange-rate mechanism made him a fortune on the trade.
Even if LFG somehow manages to restore the peg, much damage has already been done to UST.
Lunde said that LFG “may succeed in the short run” in bringing back UST to the peg, “but the long-term reputational effects and the trust in UST has surely gotten a hit by this.”
At press time, UST resumed its downward spiral, exchanging hands at 73 cents, while the price of LUNA stood at $13.68, dropping 66% in value in 24 hours.
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