US bitcoin reserve comes too late to save dollar peg

US bitcoin reserve comes too late to save dollar peg

Luna Foundation Guard's billions of dollars in bitcoin without an actual, operational infrastructure make Terra's stablecoin UST vulnerable to a "Soros-like attack," according to one analyst.

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

As digital assets collapsed along with traditional markets, the stablecoin was left vulnerable to a market crisis by the lack of an established formal structure for the project's foreign exchange reserve to prevent a crisis of confidence in the UST's dollar peg.

Instead, officials were forced to improvise solutions. They offered $1.5 billion in cryptocurrency loans to maintain the peg, and later sought to raise fresh capital to support the project. (A spokesperson for the project did not immediately respond to a request for comment.)

LFG accumulated more than $3 billion in its reserve, mostly in bitcoin, before UST lost its bond for the first time on Sunday. But the plan to tie the reserve to the blockchain with a smart contract to stabilize UST in a crisis was still weeks away from launch.

Late Tuesday, the UST changed hands for under 80 cents.

"The reserves had reached the desired size, but the infrastructure to use the reserves was not there," said Vetle Lunde, an analyst at Norwegian crypto research firm Arcane Research. "Add to that a bleeding market and poor weekend liquidity, and you have a great opportunity to attack."

UST is the largest algorithmic stablecoin with a market cap of more than $18 billion before losing its peg to the dollar over the weekend and falling to $0.68 on Monday, rocking the crypto market.

Algorithmic stablecoins are designed to maintain their price peg through a system of trading incentives based on game theory. In UST's case, this meant a decentralized blockchain protocol involving the creation and reduction of supply of a related token, LUNA.

To allay those fears, Terraform Labs, the company developing the Terra blockchain, joined with other investors to create an organization called Luna Foundation Guard and began amassing a reserve that would support the UST peg in a crisis.

LFG went on a buying spree, filling the reserve with about $3.5 billion worth of crypto assets and becoming one of the largest single Bitcoin holders in the market - but without a working system to deploy the reserve in the event of a crisis.

According to a proposal by Jump Trading, a trading firm and an investor in LFG, the reserve would work as follows: If the UST price falls below $0.98, traders could exchange UST for bitcoin (and other cryptocurrencies in the reserve) at the fixed price, creating demand for UST with an arbitrage incentive.

However, the crisis occurred before the system could be implemented.

Jose Maria Macedo, a council member of the Luna Foundation Guard, told CoinDesk that the bitcoin swap mechanism is expected to be delivered by the end of next week by the development team of Astroport, a token exchange built on the Terra blockchain.

Do Kwon, co-founder of Terra developer Terraform Labs, tweeted Monday that the launch of the test network is still a few weeks away.

There has been a lot of talk lately about the vulnerabilities of algorithmic stablecoins. Critics say they are inherently unstable in a market downturn and market participants can exploit vulnerabilities in the design.

Sean Farrell, an analyst at FundStrat, wrote in a report Tuesday that "we have ample reason to believe that the 'run' on UST was no accident, but a deliberate exploitation of UST's (clearly vulnerable) architecture."

According to Farrell, the turmoil occurred as follows:

  • Before panicking, LFG withdrew about $250 million from the UST 3pool on the Curve stablecoin exchange platform in two transactions on Saturday, ostensibly in preparation for the launch of the upcoming 4pool.
  • Immediately after the first transaction, a seller on Curve exchanged $85 million worth of UST for USDC, upsetting the UST-3pool, which included UST, USDC, USDT, and DAI stablecoins.
  • The seller dumped UST at a rate that exceeded marginal demand, creating a positive feedback loop that caused the UST price to fall to $0.98.
  • The LFG lent $1.5 billion from its reserve to traders to restore the linkage and nearly managed to bring the UST back to $1.
  • When the traditional markets opened on Monday and continued to sell off, the original short seller apparently continued his market swaps on Curve, knowing that few buyers would step in to save the algorithmic stablecoin.
  • Market makers began selling bitcoin to prop up UST, but then realized that this would only make matters worse as falling prices reduced the ammunition available to prop up the peg.

"This is reminiscent of Soros' attack on the Bank of England in the 1990s, although the attack on the UST peg is a much lower-hanging fruit for sufficiently capitalized companies," said Arcane Research's Lunde. George Soros' hedge fund successfully bet against the pound sterling exchange rate mechanism and made a fortune.

The credibility of the UST

Even if LFG somehow succeeds in restoring the exchange rate peg, much damage has already been done to the UST.

Investors are pulling their money out of Anchor, the largest yield protocol based on the Terra blockchain, which has sparked most of the demand for UST. According to the protocol's dashboard, about 60% of deposits have been withdrawn within a few days.

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 shore up its reserves.

Lunde said LFG "may succeed in the short term" by taking UST public again, "but the long-term impact on UST's reputation and confidence has certainly taken a hit as a result."

At press time, UST continued its downward spiral, trading at $0.73, while LUNA's share price was at $13.68, losing 66% of its value in 24 hours.