In his communications with them, Kwon also said another outcome was that bitcoin-backed algorithmic stablecoins could be liquidated and take everything down with them “in a catastrophic failure that will take a long time, if ever, to recover from”.
To prepare for this kind of liquidation event, Kwon and the Luna team had started buying bitcoin in February in a bid to build a treasury. Like a central bank, it would accumulate foreign currency reserves to support their own currency should it collapse.
Kwon had planned to bank $US10 billion of bitcoin to defend UST should it be required, but he only reached a third of his target. Faith in UST, which at $US26 billion was the third-most used stablecoin, was critical – not just to Kwon’s reputation, but to the thousands of portfolios that used UST to represent $US1 on the books.
When the panic started, Kwon began selling bitcoin and buying UST. That wasn’t enough. By Tuesday this week, someone – or some organisations – had engaged in another dramatic UST dump of $US650 million across all the major exchanges.
The number of USTs suddenly for sale sent markets spinning. If this was, indeed, co-ordinated, it had all the hallmarks of George Soros’ famous raid on the British pound peg, which netted him millions and cemented his legacy as a fearless trader.
But this time it wasn’t the UK chancellor of the exchequer throwing money at a wall. It was Kwon. He sold his bitcoin billions to match the selling and support the price of USTs. But those trades were crashing the price of bitcoin and depleting his reserves. The game was up. The dreaded death spiral was in motion and would be almost impossible to stop.
Terra was now front-page news, dominating the airwaves and serving as a clarion call to the legion of crypto naysayers that had been predicting its demise.
On Wednesday (AEST), UST was in free-fall and its peg had decoupled so drastically from the US dollar that US Treasury Secretary Janet Yellen referred to UST by name as she once again asked Congress to pass legislation regulating stablecoins.
“I think that this simply illustrates that this is a rapidly growing product and there are rapidly growing risks,” she said.
Kwon, who had been fairly quiet on Twitter, emerged on Wednesday evening to outline a plan to stabilize his seriously unstable stablecoin. But the collapse had left a huge amount of uncertainty and distrust across markets.
By Friday, UST was buying just US8¢ in the dollar, wiping out nearly $US18 billion of value that had been relying on this asset to provide a stable unit of $US1. By the afternoon, the Luna blockchain was frozen, which meant all transactions in the coins were halted.
The rise of the Lunatics
While most stablecoins are backed by real US dollar assets, UST used financial engineering involving a sister currency called Luna to maintain its peg. Evangelists of the project dubbed themselves Lunatics and put their hearts, souls and coins into the project.
The idea was, if the UST price fell below $1, traders could “burn” the coin – or permanently remove it from circulation – in exchange for $US1 of new units of its sister cryptocurrency called Luna. This would reduce the supply of UST and raise its price.
Conversely, if UST climbed above $US1, traders could burn Luna and create new UST. This supply of the stablecoin and lowers its price back towards $US1. The idea was to encourage the market to always find the arbitrage opportunity between the UST/Luna pairing.
Despite the tiny gains traders might make from all this burning and minting, it wasn’t really enough to entice them to stick around for the long term. So, Kwon and his team at the Luna Foundation Guard, decided to pay them.
A widely used feature of many DeFi and crypto protocols is to offer participants a healthy “yield”, or type of interest rate, to reward them for their activities. And these yields can be pretty generous.
In the case of Terra, the thousands of traders maintaining the $US1 peg were collecting an 18 per cent “interest rate” for their burning and minting activity. This yield was paid in UST by the Luna Foundation Guard. And if one UST could be redeemed for $US1, then that was a pretty good return on US dollars.
It was this model that underpinned TerraUSD which, since its launch in 2018, had ballooned to become the world’s third most-used stablecoin, attracting more than $US18 billion of crypto to the system.
The profile was building. In February, Terra inked a $US40 million sponsorship deal with the Washington Nationals, the baseball team of which former US Federal Reserve chief Ben Bernanke was a big fan.
Faithfully, Terra hovered around its $US1 peg and those participating in the minting and burning were earning a terrific yield on their money. And because it wasn’t backed by US dollars or US paper, it could boast it wasn’t beholden to those pesky regulators who can spoil the free-market fun.
In the case of UST, investors could also sign up to a scheme in which they could earn a yield up to 20 per cent by loaning out their coins – at one of the highest rates in the market.
The strategy of subsiding users to participate is not too dissimilar to the Silicon Valley mantra of ubiquity first, profits later, in which start-ups raise as much money as fast as possible to grow as large as possible to achieve a sustainable scale.
Some have called this activity a Ponzi scheme. While crypto enthusiasts prefer the term “incentive mechanisation scheme”, the process of luring new investors with payments from old is indisputable.
One River Digital’s head of quantitative assets Paul Ebner describes the process as “escape velocity”. If Terra’s de facto treasury (the Luna Foundation Guard) could pay out those yields long enough to grow larger, it could diversify into a broader pool of assets.
“The network did not have enough thrust to make it into bitcoin’s digital orbit,” he said in a note to clients. “The attempt was not pointless, it was risky. The 20 per cent yield on a UST deposit was commensurate with the risk.”
But, after a week that saw the third most-used stablecoin unravel, investors of all stripes are re-evaluating just how much they understand of the mechanics powering these highly valued, but often untested assets.
Alongside the billions wiped from UST investor books, Kwon’s fortunes have also shrunk. But, fortunately for him, it seems he was never motivated by money.
“We don’t intend to walk out of this journey being billionaires,” he told The Generalist in November.