The structural risks of algorithmic stablecoins: UST de-pegging and contagion

UST’s dollar peg is being challenged after hitting lows of $0.6 on Tuesday, May 10th. The Luna Foundation Guard (LFG) finished building its $3bn treasuries last week, as we illustrate below in this article. Shortly thereafter, the $1 peg of UST was challenged over thin liquidity during the weekend. The de-pegging originated from massive withdrawals from pool 53 in Anchor, leading UST to tumble towards $0.98, leading to a sell-off in bitcoin. The sell-off in bitcoin was caused by traders anticipating that LFG would be forced to liquidate its BTC reserves to maintain the peg. The turmoil temporarily settled over the weekend, and UST again approached its $1 peg, but not for long. The "proactive strategy" On Monday, May 9th, LFG announced a “proactive strategy” to maintain the peg. LFG plans to decentralize its reserve strategy through a BTC reserve architecture developed by Astroport, with the testnet being “a few weeks away from launch” – but the foundation had to act now. Shortly after the proactive strategy was communicated, UST once again faced problems with maintaining its peg – the proactive strategy was viewed as a confirmation that the foundation was indeed willing to activate its reserves and perform discretionary open market operations to maintain the peg. UST traded for a while at around $0.95, before declining to $0.9. Then the sell-off accelerated, leading UST to trade at lows of $0.6 – well, well, well below its $1 peg. The entire UST peg ordeal felt like a clash of titans. Certain entities with the financial chutzpah to challenge the UST peg are illustrating – in real-time - the structural risks related to UST’s structure and reserve strategy. For now, the barbarians at the gate seem to win, while LFG depletes its BTC reserves in the violent battlegrounds of the market as we illustrate below. There are three major takeaways to learn from the current UST situation Algorithmic stablecoins involve structural risks. Regulators should be aware of these when building a framework vs. stablecoin providers such as Tether and Circle. BTC reserves (at least at a ratio of $3bn to $18bn market cap) are not sufficient in building confidence related to maintaining a peg. UST is currently far from being a decentralized stablecoin. The active involvement from LFG in the last few days confirms this. Luna Foundation Guard’s BTC reserves reaches 80,000 BTC... and its gone? The Luna Foundation Guard’s BTC reserves reached its initial target of $3bn after a massive $1.5bn purchase last week, leading LFG to briefly hold 80,394 BTC. Fast forward five days, and the entire reserve has been lent to market makers seeking to save the UST peg amid the unfolding UST turmoil. In late March and early April, LFG built up its BTC reserves through aggressive daily purchases. This activity stopped, and the last purchase of $1.5bn was conducted through a massive OTC deal involving Genesis and Three Arrows Capital, leading the BTC reserves to reach 80,394 BTC on May 5th. The foundation had communicated that $3bn was their initial first target size of the reserves. It seems significant that the UST peg was challenged only two days after the reserves reached the target size, on May 7th. At the time, UST had an $18bn market cap, supported by $3bn worth of BTC reserves in addition to the mint/burn mechanism of Luna. LFG responded to the de-pegging with an all-hands on deck approach, announcing a “proactive strategy” to maintain the peg on Monday, May 9th. LFG first announced that it would loan $750m worth of BTC to OTC trading firms to protect the peg and loan $750m worth of UST to accumulate BTC once the market normalizes. Shortly after that, UST’s peg once again broke. Now, LFG has lent its entire BTC reserve to market makers aiming to return to the $1 peg. According to LFG, little of the BTC has been spent by now. The situation is unclear, and this is an unfolding story. The fight for the peg will be costly, and it’s not clear if the foundation will succeed, and market participants will likely have a hard time trusting the peg in the future. While the chart above tells an extreme story regarding LFG’s BTC reserves, the story is more nuanced. LFG’s BTC address has been depleted, but the funds are currently being utilized, aiming to normalize the peg. The current size of LFG’s BTC reserves is unclear. Nevertheless, this entire situation illustrates the structural risks of algorithmic stablecoins, in this case leading to contagion in bitcoin.