Cryptocurrencies have taken a great part in today’s world as means of investment and as a currency for trade. Although many may not believe the potential it has, the industry has been growing rapidly. Recently, the market has witnessed a bit of a slump with Bitcoin hitting its 52-week low, a general downwards trend and extreme volatility across the market. A few examples could be TerraUSD (UST) or Luna. Luna has lost over 99.9% of its market cap in a matter of days. In this report, we will be looking into stablecoins, how they can be used as means of investment, and finally dive into the recent meltdown everyone is talking about.
What are stablecoins?
In order to understand what has been happening recently, we must first understand what stablecoins are. They are rather self-explanatory, stablecoins are digital assets that maintain a stable valuation. The value of such coins is pegged to another asset’s price, most likely a fiat currency such as the US dollar. Tether (USDT) is the 3rd largest cryptocurrency when we look at its market cap. Tether and USD Coin (USDC) are the major stablecoins pegging the US dollar. As a coin is pegged to the dollar, you expect it to maintain the same value thus if you buy 100 dollars’ worth of USDT, you expect it to be worth the same tomorrow and years from now.But why do people use stablecoins instead of the dollar? That is because the price is stable due to the pegging, plus the convenience and high-speed transactions in cryptocurrency payments, that comes along with holding stablecoins.
How do stablecoins work and make money?
It is quite interesting that people can make money with stablecoins in spite of their value being pegged to an underlying asset such as the US dollar or the Euro. Well, the way it is used to make profits is through lending and investing just like banks do. However due to high demand, the interest rates are very high. The potentially concerning factor behind these stablecoins is that it is done through fractional reserve banking where only a fraction of reserves are liquid for investors to withdraw. There have been cases concerning USDT since they are claiming to hold the same amount of reserves as their market cap. This might sound worrying, however, the banking systems around the world function the same way and the people seem to have no problem with it.
We talked about stablecoins that are backed by assets but algorithmic stablecoins are also existing in the market. In this case, a computer program maintains the supply of the crypto and create or destroy the outstanding supply in order to retain the price of a given token.
What happened with Terra and Luna?
Luna and TerraUSD are 2 native tokens of Terra’s network, a project developed in South Korea. The ecosystem of Terra holds over 100 different projects from NFTs (Non-fungible tokens) to De-Fi (Decentralised Finance) platforms and WEB-3 applications. Below are some projects that are in the ecosystem of Terra in different sectors.
The ecosystem of Terra has seen tremendous growth over the past year. From a market cap of $180 million at the start of 2021, they reached $15 billion in March 2022.
Luna was originally created to fulfill the purpose of bitcoin as a peer-to-peer electronic cash system. To achieve that, they have released the stablecoins, amongst them is TerraUSD, the infamous one. TerraUSD uses Luna to peg its price to the dollar. The price of UST is anchored to $1 with the support of the algorithm by burning Luna tokens and creating new USTs.
The basis of this system comes from the arbitrage concept. Arbitrage is finding small discrepancies in price between 2 different exchanges. In our case, it Works in a slightly different way.
In the ecosystem of Terra, investors can swap UST and Luna tokens both ways and they are guaranteed a price of $1 no matter what the market price is at that moment. Thus, when the price of UST is more than $1, Luna holders can swap their Luna for UST and will be guaranteed a risk-free profit. Naturally, when the price of UST is more than $1, there is more minting (creation) of UST. This dilutes the UST supply in circulation and brings the overall price back down.
This strategy also works the other way! When the price of UST is less than a dollar, holders of UST have the opportunity of arbitrage. Now more people are burning UST and creating Luna. Eventually, UST becomes scarce enough to bring the price back up.
On Saturday, May 7th, over $2 billion worth of UST was unstaked and were sold which caused the UST price to fall to 91 cents. Traders saw and used the arbitrage opportunity to swap the 91 cents worth of their UST to $1 worth of Luna. Which normally, should be okay because the system was created to favor these actions. However, an obstacle appeared in front of these traders as there is a limit of swapping Luna for UST per day, which is 100 million UST.
With UST not retaining its peg and the Terra ecosystem not keeping its pledge of swapping between the tokens, a selling spree started which dropped the UST price which currently cruises around 5 cents.
Above you can see the depreciation of UST and the relative stability it had beforehand (graph taken from coinbase). The case is even worse for Luna holders as their portfolios must have taken a significantly greater loss. After an all-time high of $120 in April, the current value of Luna is relatively negligible. It is currently cruising around one one-hundredth of a cent.
This event has caused over $15 billion worth of wealth to be wiped out. Undoubtedly, many have lost large sums of money all over the world holding Luna and UST. This has caused spotlights to be pointed on stablecoins and their reassurances. Although the case of UST is different than that of USDT or USDC due to their underlying assets, it certainly raises questions concerning all other stablecoins.
One point to always remember is that the risk-free concept does not exist in the investment world. One of the greatest attractions of the UST-Luna pair in the eyes of investors was the arbitrage opportunities that it brought. Although there was a risk-free opportunity, it was only valid as long as the system was functioning. There are always outside factors that eliminate the risk-free concept of investing which must always be taken into account.
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Boom, D. V. (2022, May 18). Luna Cryptocurrency Collapse: How UST Broke and Why It Matters. CNET. https://www.cnet.com/personal-finance/crypto/terras-luna-crypto-crash-how-ust-broke-and-whats-next/
Powell, F. (2022, May 19). Stablecoin Crash: Why Are Crypto Markets In Trouble? Forbes Advisor UK. https://www.forbes.com/uk/advisor/investing/cryptocurrency/crypto-market-crash/
Sandor, K. (2022, March 21). What Is LUNA and UST? A Guide to the Terra Ecosystem. http://Www.coindesk.com. https://www.coindesk.com/learn/what-is-luna-and-ust-a-guide-to-the-terra-ecosystem/
What are Stablecoins and How to Earn Passive Income. (2022, May 13). http://Www.cabital.com. https://www.cabital.com/blog/stablecoins-and-how-to-use-them-to-generate-passive-income