“King Jeremy, the wicked, ruled his world today.”
– Jeremy, Pearl Jam
Monday was a day which exposed the failure of crypto and its approach to re-doing the financial system. Monday showed an attack was possible which shifted at least hundreds of millions of dollars to the attacker, while simultaneously causing huge losses and fears for people using the system as designed. A good system would not have these flaws, and crypto’s weaknesses were on full display.
The core of what happened starts with stable coins. The three largest stable coins are all a little different:
- USDC: Run by a group called Circle, a venture of Coinbase and Meta — it allows enterprises to open accounts and they can send cash and receive an equivalent amount of USDC. Circle then holds the assets and allows enterprises to reverse the process, making it freely convertible. The core business model revolves around interest on the float and also small fees can be used to exchange.
- USDT: Called Tether — similar in theory to USDC, but run by a different group. However, Tether does not have their holdings audited, which is troubling, so the existence of the assets to back the float of Tether is unverified.
- UST: This is the TerraDollar, where all of the action happened on Monday. Terra took a different approach than USDC or UST, which they called algorithmic. Terra realized that it was unlikely that 100% of the holders of UST would claim at the same time. If they could have an algorithm that had reserves, and bought or sold whenever the price started to depeg from exactly a dollar — and people would generally not be incented to push the price, since they would end up holding lots of low or high UST. And, given the general float size, the algorithm could buy/sell as needed. In addition, UST set up a system which held huge reserves in bitcoin, which would be the reserve and also a token which would govern much of the system. This was similar to much of the DEX-type algorithm. Many were skeptical of this, since there was also a way that UST could return almost 20% a year, and it was speculated that some of this came from the investors in UST itself, making it appear as a bit of a pump-and-dump or similar type of promotion scheme.
Let’s get to Monday. UST is where the action happened. At its core, it is a pegged currency, similar to a version of the Argentine Peso which was pegged to the dollar or the early 1990s British Pound, which was pegged to other European currencies.
In theory, the peg can make a lot of sense. If a country has little investor confidence in its own currency, or wants to trade in a predictable way with other countries, a peg can solve lots of the problems, without actually using the other currency. By doing this, the country retains control over other currency related questions, like banking regulations, trading and such — and could always depeg. It’s the last piece that makes this problematic. Since a depeg is possible, the credibility of the peg depends on a belief that the pegger meets two criteria:
- The peg is able to be defended
- There is willingness to defend the peg
In 1992, there was a famous attack by George Soros’ hedge fund which ‘broke the Bank of England,’ well described in articles like this: https://historyofyesterday.com/the-day-george-soros-broke-the-bank-of-england-to-make-1-1b-4834df0605d1
At its core, the attack broke the peg by selling so many Pounds, that it forced the Bank of England to drain its reserves. As this drain happened, other owners of Pounds became concerned that they would be holding less valuable Pounds, and they wanted out. This contagion resulted in so much selling that the Bank of England eventually was forced to abandon the peg and the Pound crashed in value. In doing this, the Soros Hedge Fund made money on other trades it had which bet on the value of the Pound going down, which more than made up for any Pounds it was still holding which were now worth less.
Was this evil? Or, was the Hedge funds simply seeing an opportunity and taking it? I won’t describe morality to this, except to say that pegs are very hard to maintain over long periods of time.
The same thing happened on Monday with the TerraDollar. A group which is fully known, but speculated as Citadel at places like this (https://twitter.com/jacobcanfield/status/1523999435725938689) accumulated a large UST position. They also monitored tweaks to the UST algorithm which have to do with liquidity pools to understand the speed and quantities of UST required, which were less with some recent technical liquidity changes.
Then, on Monday — the entity started selling huge quantities of UST on the Binance exchange. This led to initial peg break, where it dropped to $0.97. In USDC, people would buy USDC at this price, knowing they could go back to Circle and sell at $1.00 — a quick sale. However, with UST, the auto-buying algorithm kicked in and started selling its reserves in Bitcoin. However, it was not able to sell Bitcoin and buy UST quickly enough and the peg continued to go down. Once this started, UST holders started to fear that the reserves were insufficient, and they would be stuck holding worthless UST, and the buying avalanche started. Systems to unstake/sell UST became overwhelmed, further fueling panic as message boards started discussing the challenges with liquidity.
In all of this, UST kept selling its Bitcoin reserves, crashing the price. Eventually, the price dipped down to $0.60, though eventually recovered after about 12 hours to the low .90s. Many panic sellers suffered huge losses in a day.
In doing this, the attacker likely made huge money through its other trades on shorting Bitcoin. Some estimates are up to a billion dollars. Wow.
And, what is left behind? A failed UST that likely will never be trusted again. A general disbelief in crypto — that there are other failure points that have not been fully exploited — which is fully deserved.
Oh, and I won’t hold UST anymore.
Was this wrong of the attacker? I’m not so sure. The system is set up to make money and provide services for its participants. The attacker just did a really good job at this.
