The Tally Newsletter, Issue 70
May 19, 2022
Welcome back for issue 70 of the Tally Newsletter, a publication focused on defi and DAO governance. We’ll keep you updated on key proposals, procedural changes, newly launched voting systems, shifting power dynamics, and anything else you need to know to be an informed citizen.
This week we cover impacts of the past week’s market turmoil across the ecosystems, focusing on pegged assets and lending protocols.
Terra Stablecoin System Faces Death Spiral Collapse
TL;DR: A rush to withdraw from UST caused the LUNA token to hyperinflate as the protocol failed to regain the USD peg.
The market took a significant hit over the past two weeks as over $40 billion in market cap evaporated, taking down top 3 stablecoin UST and the entire Terra ecosystem.
UST relies on algorithmic stabilization without collateral, which essentially means the platform’s native LUNA token is minted or burned to modulate UST supply. In expansionary conditions, this creates consistent buy pressure on LUNA which is needed to create UST; this effect played a large part in LUNA’s run up over the past year. But the system can become seriously vulnerable in cases where UST supply contracts, as declines in LUNA price could cause an accelerating cycle of LUNA minting, with the system ultimately unable to fully cover all UST seeking to exit.
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Terra’s founder Do Kwon had notably brushed off warnings of this potential for death spirals. But despite later seeking to build collateral reserves through the Luna Foundation Guard’s Bitcoin purchases, which totalled up to $3.5 billion at their peak a week ago, Terra was not able to handle UST withdraws when the tide eventually turned.
After initially falling roughly 0.5% below peg on May 7, the peg began to fail on Monday along with the price of LUNA. This coincided with when the LFG organization was planning to move some of their liquidity from the UST 3pool to the 4pool on Curve. Over the coming days, UST made several more runs towards regaining peg but never was able to right itself.
LUNA began to be minted and released back to the market to support the peg, but a cascade of LUNA liquidations on Anchor lending protocol and collapsing buy side liquidity led to an increasing pace of issuance with token price falling to near 0. Total circulating supply expanded from less than 400 million LUNA to over 6 trillion within the space of just 3 days. This result bears out the death spiral fears associated with undercollateralized stablecoins.
Now, attention is turning to resolution plans that hope to recover some of the lost value of UST and LUNA holders. Terraform Labs has pushed for a plan to relaunch Terra as a new chain without native algorithmic stablecoins. Newly created tokens would be allocated across UST holders, LUNA holders (separate allocations for those holding before and after the depeg event), and developers, but would purposefully remove TFL’s own stake.
While there is some community support for a fork, the implementation and governance process raise some difficult questions. Terra had previously disabled new staking transactions to protect the chain from attacks with the hugely inflated LUNA supply, so any buyers after the depeg have essentially been stripped of voting rights. Additionally, UST holders are set to receive only 30% allocation to the new chain, which is relatively low considering Terra’s implicit commitment to put UST holders first. This shows the risk of unsecured credit to protocols, as debt holders can’t enforce their rights to preferential repayment during a default.
We’re also still uncovering collateral damage outside of the immediate Terra ecosystem. Funds, defi protocols, and fintechs are all in the crossfire due to UST’s spectacular collapse. Among decentralized protocols, algo stablecoins and higher risk lending protocols faced the greatest losses:
Kava’s USDX stablecoin faced massive losses due to fixing UST oracle price to $1, which allowed undercollateralized minting during Terra crash
Interestingly, in all of the above cases losses were caused by unsound oracle configuration rather than prices moving too fast to liquidate positions. Certain other defi protocols with Terra exposure, including Abracadabra’s MIM stablecoin and the Solend lending protocol, seem to have fared better with no apparent insolvencies.
Authorities are now beginning to take stock of the situation; US lawmakers are prioritizing stablecoin regulations, while Korea has reactivated a financial crimes team to investigate the Terra collapse and seek a tax settlement with Do Kwon and Terraform Labs.
Tether Faces Short Lived Loss of Peg
TL;DR: USDT faced a liquidity crisis but was able to recover within hours as market makers began processing redemptions.
While Tether is based on a fully collateralized model with cash and debt securities matching to issued USDT, it faced a short term panic and liquidity crisis as Terra UST began to spin out of control. Marketwide average USDT price fell as low as $0.96, while certain spot and perpetual exchanges fell below $0.90.
This had the unusual effect of briefly pushing up the reported price of certain other stablecoins including USDC, BUSD, and DAI, as much of crypto’s pricing data is centered around USDT pairs on centralized exchanges.
While exact reasons for the depeg are less clear than UST, there are a few likely forces at play. In times of severe market distress often will try to obtain the most liquid, cash-like assets available. USDT has very high usage and volumes across the crypto space, but the cumbersome and costly (0.1% fee, $1,000 minimum) redemption process may have concerned users looking for a safe haven.
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Despite improving transparency, Tether also faces continued concern over the safety of their reserves, including recent rumors of investments in struggling mainland China property developers. And the huge volatility and market dislocations raised market maker’s effective cost of capital, which made the multi-day process required for redeeming USDT less efficient.
As markets settled, the USDT peg has mostly recovered and Curve liquidity pools which previously were heavily unbalanced have trended towards equilibrium. While this depeg hasn’t been nearly as severe as UST, Tether has seen a drop in confidence as shown by their continuing outflows and declining market capitalization.
The ability to redeem roughly $9 billion over a week seems to disprove some of Tether’s harshest critics, who maintained it was a fully unbacked scheme. But on the other hand, there are concerns that Tether invested large parts of their reserve into riskier or less liquid assets, rather than the cash and treasuries common in other stablecoin reserves. Growing redemptions could force Tether to release their most liquid assets first, potentially leaving late holders facing losses from fire sales on commercial paper or undisclosed credit impairments.
stETH in the Spotlight as Peg to ETH Faces Pressure
TL;DR: Forced selling of assets and a general climate of fear have led to a nearly 4% discount opening up vs ETH.
Amid the general market panics centered on stablecoins, stETH also faced significant pressure. stETH is fully backed by ETH staked on the beacon chain with Lido, but because withdrawals aren’t currently enabled the stETH peg is maintained through liquidity on Curve.
Jump Crypto may have kicked off the deleveraging cycle with tens of thousands of ETH withdraws from the Curve pool to help stem UST’s collapse. But in the market’s panicked state, it took on a life of its own with stETH falling as much as 5% below peg at its lowest point. Contributing factors included hundreds of thousands of stETH leaving Terra’s Anchor protocol, and forced deleveraging of stETH yield strategies on Aave which had ballooned to billions of dollars in value in April. Structured products based on the Aave leverage strategy including icETH may have also been forced to rebalance at a loss.
The Lido team responded quickly by incentivizing a second Curve liquidity pool between ETH and stETH (in addition to their existing pool). The new “concentrated” pool used a ramped up 1000 amplification factor vs the original pool’s 50, which means nearly all of the pool’s assets will be allocated to stETH while below the peg. Sopping up excess supply released from Anchor and Aave seems to have avoided the worst risks of disorderly stETH liquidations.
Takeaways from Recent Market Stress
With all of the bank runs taking place over the past weeks (including a potential run on Convex’s cvxCRV just this morning), it begs the question if any pegged assets are safe? There are a few learnings that we can draw from these events to help reduce negative impacts in the future.
Collateralization is key: While undercollateralized UST and DEI stablecoins (among others) seem to have permanently lost their peg, other pegged assets including USDT and stETH have largely recovered already. And assets with the greatest transparency and access to reserves such as DAI and USDC were largely unaffected.
Risk accumulates in “safe” places: The runs on pegged assets over the past week were exacerbated by the market’s overconfidence and reliance on their stability. stETH is an example, with hundreds of millions of ETH borrowed against it on the assumption that the peg was rock solid. Conditions can deteriorate quickly if this accumulated leverage is forced to unwind, and projects should place a greater emphasis on resilience and stress testing to avoid the worst impacts of these panics.
Check out our latest blog posts from the Tally content guild:
June DAO NYC conference beginning to take shape:
Tribe DAO moves towards modular governance structure:
Coinbase to launch centralized liquid staking platform:
Cosmos cofounder Jae Kwon offers controversial airdrop incentive for voters who oppose Cosmos Hub proposal 69:
Juno proposal 20 includes error sending “Junowhale” funds to incorrect address, now corrected in proposal 21:
Anything we missed? New developments or protocols you’d like to see covered? Drop us a line at firstname.lastname@example.org