A key lesson from the recent crypto market meltdown triggered by the freefall in Luna’s price is that stablecoins need to be backed by less volatile tokens, according to a new report by Huobi Research Institute titled “What can we learn from the Luna bloodbath?”
With the price of Luna plummeting from US$87 on 5 May to US$0.0005 on 13 May, Terra’s widely adopted stablecoin UST fell from the peg of 1:1 USD to 0.03:1 USD. The fallout impacted the entire cryptocurrency market cap and triggered a fire sale of Bitcoin, spreading to other stablecoins.
The Report noted that the crisis was precipitated by a coordinated ‘Soros-type’ attack, where the perpetrator shorted UST on centralized exchanges to bring down the price of Luna as well as Bitcoin. This served to liquidate the asset portfolio of the Terra chain and LFG (Luna Foundation Guard), the organization responsible for managing Luna. Consequently, the entire Terra chain suffered from a liquidity crisis as Luna’s market cap could no longer support that of UST, leading to a complete loss of liquidity for Luna.
To better manage and defend the peg between stablecoins and assets in future, the collateral should be rebalanced with less volatile tokens that do not suffer from systematic risks of the overall crypto market. For example, the Bitcoins raised can be used to borrow USDT or USDC as collateral, while opening short positions with some longs as insurance during a market liquidity crisis.
While some centralization will help in asset rebalancing and safeguarding against future coordinated attacks, this does not undermine the premise of decentralization in the crypto industry.
The Report’s author, Huobi Research Institute researcher Dave Chan, explained that asset managers, hedge fund traders and venture capitalists wield tremendous influence in the crypto industry. While the industry pursues the goal of decentralization, there must be a centralized element to guard against another coordinated and centralized attack against supply elasticity, like what was seen with Luna.
Chan said: “More collaterals and risk diversification can be done with an increase of Luna market cap by the centralized team to protect the decentralized world. This also applies to tokens with maximum supply. It is because when circulating supply is limited in the market, a handful of wealthy individuals can deploy coordinated strategies to manipulate the remaining circulating liquidity on the market.
“Chains with a maximum limited supply should be aware of and protect themselves from attacks similar to this Luna liquidity crisis. After all, decentralized stablecoins are vital to the development of the entire cryptocurrency ecosystem.”
To download the full report, click here.