SwissBorg report explains reason for the “demise spiral” of UST

by Cryptospacey

The Swiss-based crypto change, SwissBorg, has launched a report on the dangers surrounding Terra’s stablecoin, UST. The token is at the moment present process excessive volatility, buying and selling at simply $0.59 at writing. SwissBorg issued a danger warning to customers on Could 10 and paused withdrawals of UST on the identical day, hours earlier than Binance adopted go well with. The report was accomplished in April, and virtually all the dangers they recognized are at the moment enjoying out.

Dangers of TerraUSD (UST)

Not like different stablecoins comparable to USDT or USDC, backed by fiat collateral and different liquid property, UST is an algorithmically backed token. CryptoSlate has obtained a report from SwissBorg’s DFi workforce on UST dangers. The report defined, “at any time, customers on Terra can burn $1 of LUNA to mint 1 UST, or burn 1 UST to redeem $1 value of LUNA. Subsequently, the destiny of UST and LUNA are intently linked, and so are the dangers concerned.” Importantly. It highlighted 4 key areas of danger;

  • A demise spiral of UST-TerraLuna
  • Anchor Protocol dangers
  • UST lack of peg
  • A structured mannequin for default.

Demise spiral of UST-TerraLuna

SwissBorg recounted a possible “demise spiral” between TerraLuna and UST which might trigger LUNA to crash and additional emphasize a financial institution run on UST. LUNA is at the moment buying and selling down 90% since Could 9, indicating that this state of affairs is now enjoying out with UST additionally down 30%. The report explains the demise spiral intimately.

“If LUNA’s value is below stress, UST holders might be fearing that the UST peg is in danger and resolve to redeem their UST positions. So as to take action, UST is burnt and LUNA is minted and bought available on the market. This might exacerbate additional the decline of LUNA’s value, pushing extra UST holders to promote their UST. This vicious cycle is know and ‘financial institution run’ or ‘demise spiral’

UST death spiral
Supply: SwissBorg UST Threat Report

Anchor Protocol Threat

Anchor Protocol is the Terra ecosystem platform that gives excessive curiosity in UST staking. The platform has provided as much as 19% in latest weeks with a peak TVL of round $15 billion. The TVL has plummeted over the previous few days, with each deposit and borrow values free falling.

Anchor TVL
Supply: Anchor Protocol

SwissBorg recognized the danger right here as “if the worth of LUNA (and bLUNA) falls, this might set off a liquidation of the LUNA collateral positions. UST would then be burned again into LUNA, additional exacerbating the LUNA value lower.”

Through reviews from customers on Twitter, quite a few traders have been unable to entry their Terra Station wallets as a consequence of community congestion resulting in liquidations.

An lack of ability to entry wallets has brought on customers to be unable to deposit funds to lower their LTV, forcing liquidation. This seems to be partly answerable for the steep decline in LUNA’s value over the previous week. SwissBorg particularly said of their report that “any problem with Anchor would seemingly trigger a cascade of UST redemptions with all the results beforehand talked about.”

UST lack of peg

Swissborg outlined a possible state of affairs whereby “a demise spiral together with a cascade of liquidations in Anchor might trigger the market capitalization of LUNA to fall under the market capitalization of the circulating UST.” As seen on the CryptoSlate coin tracker, this has now performed out, with LUNA dropping to simply $370M in market cap.

luna cap
Supply: CryptoSlate

SwissBorg recognized this example alone as being extremely correlated with a danger of UST de-pegging. The present state of play has this as simply one of many components affecting the Terra ecosystem. The under graph exhibits an occasion in Could 2021 the place the market cap crossed for a quick interval and its impact on the UST peg.

ust luna cap crossing
Supply: SwissBorg UST Threat Report

Structured mannequin for default

SwissBorg recognized the Merton mannequin for assessing the danger of default as making use of to an evaluation of the dangers related to UST.

“The Merton mannequin makes use of the Black-Scholes-Merton possibility pricing strategies and is structural as a result of it supplies a relationship between the default danger and the asset (capital) construction of the agency.”

The report illustrated how the complicated components used within the Merton mannequin analyses the danger of an asset falling under its legal responsibility threshold, as proven under.

merton model
Supply: SwissBorg UST danger report

Regarding the Terra ecosystem, the report decided the likelihood of UST shedding its peg.

• Asset worth A is represented by the market capitalization of LUNA
• Liabilities worth L is represented by the market capitalization of UST
• if at a given time horizon T the market cap of Luna is smaller than that of UST, the UST peg is misplaced

The above information was charted to indicate the likelihood of UST shedding its peg each day. In Could 2021, the danger rose to simply below 100% earlier than falling again to twenty% in November. The menace had been steadily rising to 60% as of April 2022. At current, UST, buying and selling at $0.59, has definitively misplaced its peg.

Threat conclusions

SwissBorg concluded that “the destiny (and dangers) of UST are strictly linked to that of LUNA. Any convergence available in the market capitalization of LUNA towards that of UST poses critical dangers of shedding the peg.” Their advice was to observe the place of UST with LUNA intently, watch the TVL of Anchor Protocol for a decline, observe market volumes for LUNA to make sure liquidity, and monitor for a lower in demand for Terra stablecoins.

At current, all of those circumstances are true. LUNA has dropped 90%, UST is down 30%, Anchor Protocol TVL is down 60%, and demand for Terra stablecoins is flatlining. Additional, a drop within the complete market cap of crypto as a complete has created an ideal storm for a black swan occasion regarding the Terra ecosystem. Will Terra survive this storm, or are tens of billions of {dollars} value of tokens about to be wiped from the face of the earth?

No matter whether or not Terra can recuperate, there are many traders who won’t be able to as a consequence of Anchor Protocol liquidations.

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