A $3.5 Billion Bet That Bitcoin Will Become A ‘Backup Currency’ For Crypto Is Put To The Test

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Pedestrians walk past a display of cryptocurrency Bitcoin on February 15, 2022 in Hong Kong, China.

Anthony Kwan | Getty Images

A multi-billion dollar bet that bitcoin could act as a “reserve currency” for the crypto economy is already being tested as UST, a controversial stablecoin, struggles to maintain its $1 peg.

UST fell nearly 99 cents over the weekend, fueling fears of a possible “bank run” that could force Terra, the project behind it, to dive into a $3.5 billion stack of bitcoin to back the token.

Now the Luna Foundation Guard, an organization founded by Terra’s inventor Do Kwon, says it will lend $750 million in bitcoin to trading firms to hold UST’s price peg. But that has done little to allay investor concerns about the implications for bitcoin.

What is UST?

UST, developed by Singapore-based Terraform Labs, is known as an algorithmic stablecoin. It aims to perform the function of stablecoins such as tether, which track the price of the US dollar but without actually holding any money in reserve to back it up.

Instead, UST – or “terraUSD” – is created by destroying a sister token known as luna using smart contracts, lines of code written into the blockchain.

“For example, if you have $405, and you burn one luna, you should be able to knock 405 off the UST stablecoin,” explains Carol Alexander, a professor of finance at the University of Sussex.

The same goes vice versa – new luna is minted by burning UST and other algorithmic stablecoins that Terra supports.

Terra’s protocols also feature an arbitrage mechanism, where investors can take advantage of differing prices in each of the tokens. For example, excessive demand for UST could cause the price to rise above $1. That means traders can convert $1 worth of luna into UST, and take the difference as profit.

The model is designed to equalize supply and demand for UST. When the price of UST is too high, users are incentivized to burn luna and create new UST, increasing the stablecoin’s supply while reducing the amount of luna in circulation.

“The luna is getting scarcer, making it more valuable, and that value is transferred to UST,” says Alexander.

When the price of UST is too low, the reverse happens: UST is burned and luna is struck. In theory, that should help stabilize prices.

The problem

“This assumes normal market conditions,” said David Moreno Darocas, a research analyst at CryptoCompare.

“During periods of high volatility and one-sided buy/sell activity for UST, the above stabilizer may not be sufficient to maintain the peg in the near term.”

There have been multiple instances where UST has been disconnected from its $1 pin, raising concerns about the viability of its economic model, especially in a situation where multiple people are trying to exchange their tokens at once.

The latest challenge arrived this weekend. Hundreds of millions of UST were sold on Anchor, Terra’s flagship, as well as Curve and Binance, resulting in accusations of a “coordinated attack” on the stablecoin.

“Men will literally attack a stablecoin in vain instead of going into therapy,” Do Kwon, the South Korean crypto entrepreneur who co-founded Terraform Labs, said in a tweet that has since been deleted.

‘Spare currency’

To allay concerns about the stablecoin’s sustainability, Kwon plans to purchase up to $10 billion worth of bitcoin through a non-profit called Luna Foundation Guard. These funds would provide a safety net in the event of a dramatic drop in UST’s value.

The idea is that bitcoin would act as the “reserve currency” for the Terra ecosystem, similar to how central banks hold large amounts of dollars in their foreign exchange reserves.

LFG bought another $1.5 billion in bitcoin last week, bringing its total reserves to about $3.5 billion. On Monday, however, the organization said it was taking steps to “proactively defend the stability of UST”.

That includes lending $750 million worth of bitcoin to trading companies to “protect the UST peg.” and another 750 million to UST being lent to buy more bitcoin “as market conditions normalize”.

“In the case of most of these algo stablecoins, we’ve seen that the teams behind the project usually need to step in – so these aren’t fully decentralized or independently managed yet,” said Vijay Ayyar, head of business development and international at crypto. trade luno.

What it means for bitcoin

Investors are concerned that UST’s bitcoin underpinning will lead to further pain for the cryptocurrency.

The world’s largest digital currency fell below $33,000 on Monday, falling to its lowest level since July 2021. It last traded at around $32,921, a 6% drop in the past 24 hours.

LFG’s intervention “will increase selling pressure,” said Derek Lim, head of crypto insights at the Bybit exchange. “BTC is likely to move lower before rebounding as shortsellers take profits.”

Kwon insisted that LFG is “not trying to get out of its bitcoin position”.

“As the markets recover, we plan to repay the loan to us in BTC, increasing our total reserves,” he said.

The plan is to eventually allow UST holders to exchange their tokens in exchange for bitcoin. Bitcoin would play the role normally occupied by luna in a crisis scenario, where arbitrageurs buy UST and then exchange it for discounted bitcoin. But this is still weeks away from implementation and it’s unclear how it would work in practice.

The biggest risk going forward would be another depegging of UST forcing LFG to liquidate its bitcoin holdings, said Hendo Verbeek, head of quantitative trading activities at Faculty Group. That in turn could lead to further liquidations of “over-leveraged” buyers, Verbeek said.

“This is a nightmare scenario that looks like a real result of events,” he said.



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