Written by Erik Weijers 9 days ago

How the crash of UST went down - can algo stablecoins survive this?

More is becoming clear about the circumstances that led to the crash of stablecoin UST last Sunday and Monday. There is much speculation about the impact of the UST crash on the stablecoin market. Is this the end of algorithmic stablecoins?

-- Disclaimer: this is an ongoing story, new information is constantly emerging --

It seems that a short seller took advantage of the downfall of UST and LUNA. Perhaps by shorting Bitcoin, it is speculated. Shorting is a financial tool allows one to profit from the fall in price of a currency or asset. The attacker's strategy would be based on the knowledge that the Luna Foundation Guard (LFG) would be forced to sell their Bitcoin to defend UST. The LFG had put 3 billion into their treasury in the last month (mostly BTC) with the goal of absorbing such an attack. But while this ammunition was in place, the LFG had not finished setting up the infrastructure for a counterattack. They had to improvise on the spot.

The attack

On Sunday, May 8, the alleged attacker dumped a huge batch of UST (85 million) on Curve Finance, a decentralized exchange (dex). That unhinged the pool of stablecoins: UST dropped to 98 cents. The LFG deployed 1.5 billion from reserves to restore the price, in which they almost succeeded.

On Monday, the global crypto and stock markets opened in the red. The weather conditions for a perfect storm. The short seller kept dumping UST and with a Bitcoin price that kept falling - partly due to their own sales - there was no stopping the LFG. Which didn't help is that people saw the storm brewing and en masse got rid of their UST. The amount of UST in the Anchor protocol dropped by 60% in a few days. Everyone and their mother dumped their UST, bought LUNA with it and then dumped it again.

The price of UST at the time of writing is 47 cents. Do Kwon says it is working on a rescue plan. It seems to be coming too late. Either way, much of the confidence is gone. Not only in UST but also in algorithmic stablecoins. These are stablecoins that do not have a vault of "real" dollars to defend the peg.

Forest fires in crypto

There are several ways to look at the UST fiasco. Many holders of LUNA in particular have lost money. LUNA was above $100 a month ago and is at this writing around $4. A death spiral is no joke.... Holders of UST have also lost money. This can be devastating to people's lives.

There may be lessons learnt from this downfall. Assuming Do Kwon and his friends won't run off with the remaining money, the best we can hope for is that this is a step towards a better algorithmic stablecoin. It will remain to be seen if this is the final nail in the coffin of UST, or perhaps even algorithmic stablecoins in general. One outcome is that the next candidate will use a somewhat different model and see how that works. For example, the Anchor protocol's fixed high-interest rate of 19% turned out to be a bad idea. And perhaps a peg that is allowed to move more freely is a better idea. Better alternatives for the Bitcoin reserve can probably be thought of as well. A reserve of U.S. dollars might be one such idea. But who knows? Only time will tell.

A monetary experiment has been conducted that didn't end well. Many people have lost money and that is painful. Let's hope that after the forest fire, there is fresh soil on which new trees can grow.

Regulators: told you so

Crypto is not operating in a vacuum. To become really big, sooner or later projects will have to become good friends with the regulators. As expected, US Treasury chief Janet Yellen seized upon the UST crash to point out the risks of crypto. Regulators will use the crash to tighten the reins on stablecoins. 'Told you so. You clearly can't do it yourselves, let the traditional banks do it.' That makes it less likely that an algorithmic, purely decentralized stablecoin will become and remain big. Players like USDC and Paxos may have better credentials because they have real dollars in their reserves and a good track record with regulators. Perhaps we should accept that we will have to make do with these centralized stablecoins in the future.

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