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Founders outline UST situation and why we prefer conventional stablecoins like USDC
TLDR - Ledn does not support Terra or the UST stablecoin on its platform. The events unfolding around Luna and the Terra stablecoin have had no impact on Ledn’s operations.
This weekend UST, or TerraUSD, lost its intended peg to the US dollar during a broader market sell-off. In this blog, we summarize what happened with UST, the difference between algorithmic and conventional stablecoins, and why Ledn’s proud to carry USDC on our platform.
It’s been a turbulent week in markets of all kinds, and cryptocurrency was no exception. Increase in treasury rates, macroeconomic forces, and a strengthening U.S. dollar contributed in part to the decline in the overall crypto market. You may have noticed bitcoin’s 25% drop, larger losses among most other coins, and in particular the collapse of a token called Luna and de-pegging of its associated stablecoin, UST.
UST is an algorithmic stablecoin, relying on market incentives and treasury management to maintain its underlying value. Its issuer, the Luna Guard Foundation, created a $10 billion treasury fund to be able to support the UST peg, yet as the crypto market downward spiral, the foundation had to sell its treasury Bitcoin holdings to help maintain price stability for the Terra ecosystem. Despite an announced recovery plan from its founder, Do Kwon, the pegging has severely veered off course and caused a capital run off.
We’re here to shed some light on this situation so you can get a clearer picture of what’s going on and what it means for Ledn’s services. The short story is that our risk management practices at Ledn prepare us for just these events, and our operations continued as normal, experiencing no interruption.
Ledn, and our choice stablecoin USDC, are not exposed to the same types of risk that brought down Luna and UST. To understand why, let’s break down some stablecoin basics.
Stablecoin Basics
A stablecoin is a token meant to keep price parity with target, usually USD. Ledn clients may already be familiar with USDC, the stablecoin we support on our platform.
There are two types of stablecoins - conventional stablecoins (USDC, Tether) and algorithmic stablecoins (UST, Dai). They use different methods to maintain 1:1 parity of stablecoin to dollars. If a stablecoin “maintains its peg”, this means that one unit of the stablecoin remains equal to the value of one US dollar. If the peg “breaks”, this means the price of the stablecoin is out of sync with the dollar.
Conventional stablecoins
Conventional stablecoins are the simpler of the two types. They are managed by a trusted issuer, who keeps reserves equal to or greater than the stablecoins they have issued.
The issuer accepts dollars in exchange for the stablecoin. If someone wants 1 million USDC, they can in theory send Circle (the issuer of USDC) $1 million USD and Circle will issue 1 million USDC for them in exchange. And vice versa - any stablecoin issuer should accept deposits of their stablecoin and pay them out in dollars.
As long as the issuer allows for the stablecoin to be reliably exchanged for dollars, it can be assumed that the stablecoin will remain at parity. In practice, most stablecoins are acquired on the open market by trading with other holders, and the issuance or destruction of stablecoin supply tends to only occur in large batches.
The trust model for conventional stablecoins is very simple: if there is confidence that the issuer has sufficient reserves and can continue to allow for 1:1 exchange between the stablecoin and dollar, then it can be expected for that stablecoin to trade at parity. Also, because there is a clear issuer and reserve custodian, conventional stablecoins tend to be much more subject to regulation. Reserve audits, reputational history, and other traditional ways of establishing trust are key for establishing the validity of stablecoins.
These are all methods we are familiar with at Ledn, both in how we vet the institutions we lend to, and how we remain trustworthy to our own clients. It’s our bread and butter.
Algorithmic stablecoins
Algorithmic stablecoins function differently, and are more complex than their conventional counterparts. Rather than an issuer acting as an ultimate source for exchanging between dollars/stablecoins at parity, there are programmed market mechanisms in place that incentivize the creation or destruction of stablecoin supply to keep price at parity. This ultimately involves relying on other assets (such as BTC, ETC, some native token, etc) as backing. It also means that there is a larger variety of possible structures for algorithmic stablecoins and that the risk profile is inherently different - it means that a flaw in the coding of the stablecoin algorithm could break the peg.
The algorithms depend on assumptions that may or may not turn out to be true. For example, there may be an assumption that the floating value of another asset remains sufficiently high, or that volatility remains below a certain threshold. An algorithmic stablecoin’s ability to maintain its peg is essentially a test of these assumptions, and that it was coded correctly.
To properly vet algorithmic stablecoins requires a different set of skills - one needs to have confidence in the quality of the smart contract that issues it, and in the assumptions behind it. Additionally, once a lot of the complexity is peeled back, it turns out that many algorithmic stablecoins rely on a trusted centralized entity (e.g. LFG). As a result, they often end up with the combined risks of conventional stablecoins as well as the added risks particular to algorithmic stablecoins.
Luna and UST
Now that we have a more firm understanding of algorithmic stablecoins in general, let’s take a close peek at the UST situation.
The UST peg mechanism works like this: holders of UST could programmatically redeem UST for $1 worth of LUNA tokens. At the same time, LUNA tokens could always be burned for their dollar value in UST.
This might sound similar to the conventional model where the stablecoins can be redeemed for dollars using the issuer’s reserve. But the key difference here is that the LUNA tokens were not held in reserve - rather, are traded on the open market, and their value can fall relative to the dollar that UST is supposed to be tracking.
To mediate this risk, the Luna Guard Foundation (LFG), which issued LUNA and UST, started building up a reserve of other assets to provide extra support. These assets included BTC, USDT, USDC, AVAX, and others.
As the crypto market tanked over the last week, LFG liquidated nearly 42,530 BTC (worth ~$1.3 billion) and other assets from its reserves to prop up its UST peg. This sell-off added additional selling pressure to an already dipping market, exasperating the pressure that UST was under.
UST dropped below its crucial $1 level over the weekend before things took a sharper turn on Tuesday. In 24 hours, LUNA lost ~97% of its value while UST went down by nearly 64% before partially recovering. It now trades around $0.66.
Ledn’s Perspective
Although they are both referred to as “stablecoins”, USDC, and UST are very different things.
USDC, the stablecoin created and managed by Circle, has dollar for dollar reserves that are attested by Grant Thornton on a monthly basis (you can check their attestations here) - much like Ledn does ongoing proof-of-reserves attestations every 6 months. USDC was also founded by Coinbase - an investor in Ledn, and Circle. Both are highly compliant companies based in the U.S.
In contrast, algorithmic stablecoins have inherently volatile designs that are based on a series of assumptions and volatile collateral.
At Ledn, we like to keep things simple, transparent, and accessible - so that everyone can verify. And we believe USDC is a stablecoin that allows our clients to do just that.
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