Did A Planned Attack On UST Cause This Crypto Crash?

Last Monday the cryptocurrency and NFT markets experienced their worst week in a long time. Meanwhile, most other financial markets are suffering from the fear of increasing interest rates, as well as rising geopolitical tensions. These pressures alone would likely have caused a crypto downturn, but they were compounded by a separate black swan event. 

A relatively new cryptocurrency, TerraUSD (UST), went under, and it dragged everyone in cryptos and NFTs with it.

Stablecoin Mania

UST is a stablecoin, a type of cryptocurrency that has its value pegged to a certain asset, in this case, the US Dollar. 1 UST is supposed to always be worth $1. The stablecoin was created by a South Korean startup, Terra. UST and its sister token, Luna, became massively popular in Korea and abroad over the past year. UST’s market cap skyrocketed from less than $200 million in 2021 to $18 billion at the beginning of this May. Both UST and Luna broke through the top 10 cryptos by market cap. But the bigger they are, the harder they fall.

Monday, UST was trading for less than 10 cents.

UST isn’t any old stablecoin that keeps USD or crypto reserves as collateral to support its peg. It’s an algorithmic stablecoin. UST was supposed to maintain its peg by a complicated incentive system that utilizes Luna. 

When 1 UST is created, $1 worth of Luna is burned. When 1 UST is burned, 1$ of Luna is created. This was supposed to incentivize traders to burn UST for Luna when its value drops below $1 and vice versa when it rises above $1. Essentially, traders get discounted Luna for lowering the supply of UST or discounted UST for lowering the supply of Luna. Theoretically, decreasing the supply should help increase the price again and maintain the peg.

The UST algorithm worked well until May 9, 2022. In a matter of about 10 hours, UST’s price fell to $0.75. It bounced back to $0.90 the next day but that didn’t hold for long. It crashed down to 30 cents and has only dropped further since. Luna suffered a much worse fate, falling from $66 on May 8th to $0.0004 in less than a week.

Was This All A Massive Conspiracy?

There is an unusual amount of speculation swirling around the crypto community after this devastating crash. One of the most common theories is that the UST’s collapse was caused by a well-planned attack. A Twitter thread from @OnChainWizard captivated the community with this wild theory. He said that someone took advantage of a flaw in UST and the decentralized finance (DeFi) ecosystem to make about $800 million in profit.

He speculated that an attacker with deep pockets first borrowed about 100,000 BTC and sold it, effectively creating a ~$4.2 billion short position. He believes that some of this BTC was sold directly to the Luna Foundation Guard (LFG) which was building a BTC reserve to further back UST. The attacker may have then bought about a billion UST to finish preparing for the attack.

The LFG removed about 250 million UST from one of the largest UST liquidity pools (where traders can swap UST for other stablecoins) on Curve Finance in anticipation of opening a new liquidity pool on the platform. This immediately reduced the available supply of UST by a large margin.  

350 million UST was soon dumped into the Curve liquidity pool, possibly by the attacker. This drained the pool of the other stablecoins, dropping UST’s value and initiating its death spiral. However, this was only the beginning. The real de-pegging seems to have occurred on Binance, the largest centralized exchange. This could have been caused by the attacker dumping the rest of his $1 billion UST position on the exchange. 

UST price chart from TradingView

The selling pressure on Binance drove the price down further, causing retail traders to panic and sell their UST and Luna. The mechanism designed to keep UST and Luna afloat was rendered useless. The algorithm can change the supply of the tokens, but it can’t change the demand for them. No one wanted to trade one sinking ship for another. 

LFG sold their BTC reserves to try to save the peg, but it wasn’t enough. However, it was enough to crash BTC, making the theoretical attacker more than $800 million on the massive short position. If this theory is true, it would be quite similar to the billionaire George Soros’ attack on the British Pound.

The simplest explanation is that the algorithm simply failed to hold the peg. UST’s mechanism works perfectly when the market is up. UST and Luna never had to face such a correction while at their ludicrously high valuations until now. The system may have simply crumbled under its own weight combined with the selling pressure every other crypto was facing. It is a bit strange that this all happened right when UST was at its weakest point, but that may just be a coincidence. 

We likely will never know for sure what caused UST to implode, but we at least know to be more cautious with similar mechanisms. 

Rippling Effects and UST Alternatives

The market-wide panic even spread to the largest stablecoin, USDT (Tether). It dipped to about $0.95 for a few hours but recovered to $1 in less than 24 hours. Tether isn’t an algorithmic stablecoin, but instead uses large reserves as collateral to back its peg. The price dip seems to have been caused by smaller retail traders panicking that USDT may soon follow UST and begin to crumble.

Tether lets you redeem USDT for USD held in its reserves, but the minimum amount is 100,000 USDT. Many large traders made the easiest 5% of their lives, buying up more than 100k USDT at $0.95 and swapping it to Tether for $100k USD. This dip wasn’t enough to de-peg USDT, but the panic wasn’t unfounded. There is a long list of reasons why Tether should not be entirely trusted. The main one: they lied to the public about their backing for years. 

The Commodity Futures Trading Commission (or CFTC), a U.S. independent government agency, found that Tether only held a small percentage of the cash and cash equivalent reserves that they claimed to have. Instead, USDT was backed by a modest amount of cash (less than 3%), fiduciary deposits, corporate bonds, treasury bills, precious metals, and about 50% commercial paper. And yet, for their crime of lying to the public, Tether only suffered a $41 million fine. 

This isn’t to say that USDT is on the brink of collapse. They might not be. However, there are much safer stablecoins out there, namely USDC. USDC is not entirely backed by USD either, but the composition of its reserves is far superior to USDT. A majority of its reserves are in cash and cash equivalents (~61%) with only a small percentage of riskier assets like commercial paper (~9%). 

UST’s downfall was a painful reminder that the crypto market is rarely completely safe. Even the assets that we consider the most secure, namely stablecoins, can quickly fall apart.

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