It has been over a week since Terra UST went offline, causing a massive market crash.
UST’s market capitalization has plummeted from $18.7 billion to $1.15 billion at the time of writing. Similarly, the Terra LUNA token fell from $21 billion to $236 million at its lowest point on May 13. The event was a wake-up call for investors who were surprised by the severity of the losses, the repercussions of which will be felt in a few years. now.
Previously, the UK had expressed interest in recognizing stablecoins, even proposing further legacy integration. But now, the mere mention of them is enough to make anyone nervous. Has anything changed?
How Terra UST Maintains Price Stability
The first sign of trouble came on May 9 when UST broke its 1:1 peg to the dollar. Unlike other stablecoins like Tether, UST maintains its peg through an algorithmic process that moderates supply and demand alongside the LUNA token.
If the demand for UST is high and the supply is low, the price of UST increases. Also, the price of UST decreases when demand is low and supply is high.
Controlling this process and linking UST close to its $1 peg, the Terra ecosystem operates through the interaction of two groups of UST and LUNA. By minting one while burning an equivalent value in the other, the pools contract and expand in proportion to each other.
“To maintain Terra’s price, Luna’s supply pool is added to or subtracted from Terra’s supply. Users burn Luna to mint Terra and burn Terra to mint Luna, all incentivized by the algorithmic protocol market module.”
When the price of UST is too high relative to $1, the protocol incentivizes users to mint UST and burn LUNA. The additional UST supply makes the UST pool larger and lowers its price. This action also contracts the supply of LUNA and acts as a mechanism to increase the price of LUNA.
The opposite situation is when the price of UST is too low relative to $1, this means that there is more supply than demand. The protocol incentivizes users to mint LUNA and burn UST in this case. The contracting supply of UST increases the shortage and pushes the price higher towards the fixed price. At the same time, the price of LUNA falls due to the additional supply available.
Supporting this is the market module that incentivizes users to take the appropriate action by providing arbitrage opportunities. Through the Terra Station Wallet, users can make market trades to mint and burn tokens accordingly and profit from doing so.
Overview of the Terra UST stablecoin disaster
Weeks earlier, UST had risen to the third-largest stablecoin by market cap ranking. A major factor behind this was the generous staking rewards on offer, with up to 20% available to token holders.
However, in order to move towards sustainability, Anchor Protocol, Terra’s loan and lending platform, had started discussions to implement ‘a semi-dynamic rate of return’. It proposed to increase or decrease the interest rate, in 1.5% increments, based on Anchor’s reserves increasing or decreasing by 5%, respectively.
Word soon spread that the generous participation fee might not be available for much longer, leading to an exodus of users. On Friday, May 6, Anchor had approximately 14 billion UST on deposit. By Sunday May 8, this had dropped to 11.8 billion UST.
After Sunday, there was a near-vertical drop in deposits as users fled.
@0xHamz documented a UST supply rush hitting Binance on May 7. Binance handles the largest amount of UST volume of all providers, responsible for around 20% of total UST transactions.
At that time, no one knew what was about to happen. However, @0xHamz noted a 25 basis point drop in the fixed price of UST on the exchange and called the event meaningless.
It means that there is a lot of supplies in a place that does not make sense.
So that supply needs to go somewhere that makes sense or change to something else.
The options are
– Deposit UST in Anchor
– Exchange UST for USDT/USDC
— 0xHamZ (@0xHamz) May 7, 2022
The UST flight soon spread, putting further downward pressure on the token. An investor unraveled 85 million US dollars on the curve for USDC. This sped up the unbinding and no one seemed to absorb the supply to rebalance the pool.
Rumors exist that the collapse was the result of an attack orchestrated to bring down Terra’s ecosystem. While possible, it is equally likely that the likelihood of falling rates will trigger an exodus of users leading to a cascade of more users leaving.
The world took stock over the next few days as UST and LUNA plunged further into the abyss.
Immediately after, US Treasury Secretary Janet Yellen called for new regulations to oversee stablecoins. She added that her department was actively working on an incident report.
Shortly after, US Securities and Exchange Commission Hester Peirce reiterated Yellen’s call, adding that the events on Terra have accelerated work toward stablecoin regulation.
Although Yellen or Peirce did not explicitly state it, the general mood towards stablecoins, algorithmic or not, had deteriorated significantly, at least from the point of view of the US authorities.
Commenting on the situation, Massachusetts Rep. Jake Auchincloss proposed that stablecoins be audited by the federal government, be under the supervision of a federal office such as the Comptroller of the Currency, show 90-day proof of liquid reserves (although this would be irrelevant for algorithmic stablecoins, and having insurance for clients.
Similarly, Bank of France Governor Francois Villeroy de Galhau said that crypto assets threaten legacy finance if they are not regulated and interoperable across jurisdictions. In response, EU lawmakers are proposing to speed up the launch of an EU central bank digital currency.
The UK stands apart from the herd
Last month, UK Chancellor Rishi Sunak announced plans to turn the UK into a tech hub for crypto assets. This implies a series of reforms in favor of cryptocurrencies, such as the recognition of stablecoins as a valid payment method, financial sandboxing, the development of an industrial body to interact with the government, and the revision of fiscal rules.
Seemingly unfazed by Terra’s turmoil, the UK has recently signaled its intention to move forward with pro-crypto legislation, specifically, recognizing stablecoins as a means of payment under the Financial Services and Markets Bill.
However, a spokesperson for the Ministry of Finance said that the proposed legislation does not cover algorithmic stablecoins.
The UK Treasury said the above reforms would foster growth opportunities while also enabling financial stability as the fledgling digital asset market develops.
There is a clear divergence
Although the US and the EU have taken the collapse of Terra as an opportunity to crack down, the UK is going the other way and seizing the opportunity presented to it.
This means a clear divergence in policy, which will end only one way: capital flight to crypto-friendly jurisdictions.
Furthermore, this divergence will become more apparent in the coming months as nations “pick a side.” The question is, who will join the UK?
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