Stablecoin support included $3 billion worth of cryptocurrencies to help keep its value at $1. But in the wake of the cryptocurrency collapse, the Do Kwon-backed nonprofit foundation used nearly all of its bitcoin reserves in a failed attempt to help TerraUSD return to its normal level.
The collapse of the TerraUSD cryptocurrency has traders wondering what happened to the $3 billion in reserves meant to protect it.
Terra is a blockchain network built on the Cosmos SDK, which is designed to create stablecoins. In Terra, each stablecoin is converted into its own blockchain token called LUNA.
TerraUSD (UST) is a stable coin, hence it should maintain its value at $1. But after the crash earlier this month, the coin is worth only 3 cents.
Stablecoins are part of a cryptocurrency ecosystem that has grown dramatically in recent years. Stablecoins make up about $160 billion of the $1.3 trillion cryptocurrency universe. As the name implies, these assets are supposed to be independent of market fluctuations and are needed to stabilize exchanges between cryptocurrencies, working as stable intermediaries. The lack of volatility allowed the value of other cryptocurrencies to be pegged to stablecoins.
The nonprofit foundation backing TerraUSD has deployed nearly all of its bitcoin holdings to help it regain its typical $1 level, according to an analysis by Elliptic Enterprises Ltd. a cryptocurrency risk management company. Despite this, TerraUSD has deviated further from its assumed value.
In recent months, crypto traders and market watchers have warned on social media that TerraUSD could deviate from its $1 peg. Terra is an algorithmically stable coin, meaning it is not backed by fiat like USDT. You have to burn a dollar of LUNA to mint 1 UST, or burn 1 UST to redeem $1 of LUNA. Thus, the two coins are closely related.
As an algorithmically stable coin, it relied on traders to act as a support for the value of the stable coin, giving them incentives to earn when the value rises or falls slightly. If traders’ desire to hold on to the coin wanes, some warn, it could trigger a wave of selling of both cryptocurrencies, called a death spiral.
A report from cryptocurrency exchange SwissBorg explains it as follows:
If LUNA’s price is under pressure, UST holders could be fearing that the UST peg is at risk and decide to redeem their UST positions. In order to do so, UST is burnt and LUNA is minted and sold on the market. This would exacerbate further the decline of LUNA’s price, pushing more UST holders to sell their UST. This vicious cycle is known as ‘bank run’ or ‘death spiral’.
To avert these fears, Do Kwon, the South Korean developer who created TerraUSD, co-founded the Luna Foundation Guard, a nonprofit organization charged in part with creating massive reserves to act as a pillar of trust. Mr. Kwon said in March that the organization would buy up to $10 billion in bitcoin and other digital assets. But not much was accumulated before the crash.
Kwon’s company, Terraform Labs, funded the foundation through a series of donations beginning in January. The foundation also raised $1 billion to start building its bitcoin reserves, selling that amount of sister token Luna to cryptocurrency investment firms including Jump Crypto and Three Arrows Capital, announcing the deal in February.
As of May 7, the foundation had accumulated about 80,400 bitcoins worth about $3.5 billion. It also had nearly $50 million in two other stablecoins, Tether and USD Coin. The issuers of both stablecoins said their coins were backed by dollar-denominated assets that could easily be sold for redemption. Binance coin and Avalanche cryptocurrencies were also held in reserve.
Traders’ desire to own LUNA and UST waned after a series of large withdrawals of stable coins from Anchor Protocol, a sort of crypto bank where users blocked money to earn interest. This wave of sales grew, causing TerraUSD to fall below $1, which brought down LUNA, as well.
Luna Foundation said it began converting reserve assets into a stable coin on May 8 when the price of TerraUSD began to fall. In theory, selling bitcoins and other reserves could help stabilize TerraUSD by creating demand for the asset as a way to revive faith. It is similar to how central banks protect their declining local currencies by selling currencies issued by other countries and buying their own ones.
The foundation said it transferred bitcoin reserves to another counterparty, allowing them to make large deals with the foundation. In total, it sent more than 50,000 bitcoins, about 5,000 of which were returned, for about 1.5 billion TerraUSD stable coins. It also sold all of its Tether and USDC reserves for 50 million TerraUSD.
When that failed to support the $1 peg, the foundation said Terraform sold about 33,000 bitcoins on behalf of the foundation on May 10 in a last-ditch effort to return the stable coin to $1. In return, it received about 1.1 billion TerraUSD.
According to Elliptic’s analysis, the foundation moved funds to two cryptocurrency exchanges, Gemini and Binance, to make these transactions.
While the large cryptocurrency exchanges were probably the only institutions in the ecosystem capable of handling the large transactions the foundation had to make quickly, this also caused concern among traders as the scenario approached a death spiral. Unlike peer-to-peer transfers in crypto, specific transactions made on centralized exchanges are not visible in the public blockchain, the digital ledger underlying crypto transactions.
Despite the foundation’s graph, the lack of transparency has raised investor concerns about how funds have been used by some traders.
“We can see the movements on the blockchain, we can see the funds move to these large centralized services. We don’t know the motivations behind these transfers and whether they were transferring them to another actor or whether they were transferring the funds to their own accounts on these exchanges,” said Tom Robinson, co-founder of Elliptic.
Representatives for the Luna Foundation and Mr. Kwon have remained silent. Earlier in May, the foundation said it still had about $106 million in assets, which it would use to compensate the remaining TerraUSD holders, starting with holders of the smallest amounts. It provided no details on how that compensation might work.