UST’s Bitcoin Reserve Too Late in Coming to Save Dollar Peg

Luna Foundation Guard buying billions of dollars in bitcoin without an infrastructure ready to deploy left Terra’s UST vulnerable to a “Soros-style attack,” an analyst said.

AccessTimeIconMay 10, 2022 at 11:25 p.m. UTC
Updated May 11, 2023 at 5:09 p.m. UTC

Luna Foundation Guard (LFG)'s proposed cryptocurrency reserve to guard against a collapse of the UST stablecoin came too late to guard against the past week's market turmoil.

As digital assets plunged along with traditional markets, the lack of an established formal structure in place for the project's forex reserve – designed to head off a crisis of confidence in UST's dollar peg – left the stablecoin vulnerable to a market rout.

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.)

LFG accumulated more than $3 billion in its reserve, mostly in bitcoin (BTC), before UST first lost its 1:1 dollar peg on Sunday. However, the plan to connect the reserve to the blockchain with a smart contract to stabilize UST in a crisis was still weeks away from launching.

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.

Algorithmic stablecoins are supposed to maintain their price peg through a system of trading incentives based on game theory. In the case of UST, that meant a decentralized blockchain protocol that involves creating and reducing supply of a related token, LUNA.

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.
  • Immediately following the first transaction, a seller swapped $85 million of UST for USDC on Curve, and pushed the UST-3pool, which held UST, USDC, USDT and DAI stablecoins, out of balance.
  • 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.

UST's credibility

Even if LFG somehow manages to restore the peg, much damage has already been done to UST.

Investors are pulling money out of from Anchor, the largest yield-earning protocol built on the Terra blockchain that drove most of the demand to UST. Some 60% of its deposits have fled in just a few days, according to the protocol’s dashboard.

Kwon tweeted Tuesday that he was “close to announcing a recovery plan for UST,” while LFG is reportedly in talks to raise $1 billion to prop up its reserve.

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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Krisztian  Sandor

Krisztian Sandor is a reporter on the U.S. markets team focusing on stablecoins and institutional investment. He holds BTC and ETH.