Just as many investors were getting comfortable with the concept of stablecoins and their place in the crypto market, the TerraUSD (UST) scandal caused them to stop in their tracks.
How was a stablecoin pegged to the US dollar like UST able to implode and shave $40 billion off the crypto market cap? In this article, we'll look at how TerraForm Labs' algorithmic stablecoin worked, what went wrong, and how the consequences have played out so far.
Stablecoins are a type of cryptocurrency that maintain a relatively stable value as they are pegged to an external asset, such as the US dollar, euro, or gold. Tether (USDT) and USD Coin (USDC) are the largest by market cap of $70 billion and $53 billion, respectively. Run by centralized entities, both stablecoins have grown in popularity as they allow for fast settlement and peer-to-peer transactions and offer traders a haven in times of high crypto volatility.
Yet, with growing concern about stricter regulation surrounding stablecoins, decentralized alternatives have grown popular. The entities that produce USDC and USDT can be seized or controlled by regulators, whereas decentralized options cannot.
The UST stablecoin kept its peg to the US dollar through an algorithm, working in tandem with the Terra blockchain's native LUNA token. To keep the price of UST stable, the supply of LUNA was either added or subtracted from UST's supply. LUNA was burned to mint UST, and UST was burned to mint LUNA.
This created myriad arbitrage opportunities based on supply and demand factors, as Terra guaranteed that 1 UST could always be swapped for $1 worth of LUNA independent of the price.
When UST began to trade above its $1 peg, users were incentivized to burn LUNA and mint UST and vice versa. In other words, as demand for UST rose, so did the price of Terra's LUNA token. With a market cap of over $16 billion before things went horribly wrong, UST had become the most widely popular decentralized stablecoin.
So, what happened? Starting the weekend of May 7, 2022, UST's peg started to deviate from 1:1. Macro uncertainty was beginning to flood the crypto markets brought on by a hawkish Federal Reserve raising interest rates. Fear, uncertainty, and doubt began to have a catastrophic effect on UST.
The uncertain economic outlook pummelling tech stocks and the wider crypto market and a destabilized peg caused $5 billion UST to be quickly drained from the Anchor Protocol, a Terra ecosystem lending application offering a massive 19.50% yield on staked UST.
This sudden drop in total value locked (TVL) in the Anchor protocol caused panic in the market, causing the crypto equivalent of a bank run on both UST and LUNA. The immense selling pressure caused what's now being called the "LUNA death spiral."
In less than 48 hours, UST's value fell from $1 to $0.26. In days, LUNA went from trading at over $80 a coin to fractions of a penny. Not only was the rush for the exit on UST causing LUNA's value to plummet, but the protocol design meant that more and more LUNA was being minted consecutively, rapidly increasing its supply and diluting its value.
In a desperate attempt to halt the carnage, the Lunar Foundation Guard (LFG), which had purchased $1.5 billion worth of BTC the week prior, began to sell off its reserves of $2.4 billion. It was too little, too late, as confidence in the stablecoin evaporated, LUNA and UST became a painful memory leaving many investors out of pocket.
While there are many conspiracy theories about a planned attack on UST by a knowledgable market participant such as a crypto-native hedge fund or trading desk, no evidence has been provided. Moreover, as others have been quick to point out, whether the downfall of Terra was a coordinated attack or a freak market event, it should not have been able to happen in the first place.
As the dust settles on the horrifying event that saw many people losing their life savings, perhaps it's too soon to say how this will pan out. The Terra community, home to many talented developers and promising applications, voted in favor of a proposal this week to effectively restart the Terra blockchain from a snapshot date before the event occurred. This plan will allow dApps on Terra to continue to build using the LUNA token as currency, abandoning the failed UST stablecoin.
Time will tell whether this move will have a successful outcome. As we painfully learned from the UST demise, a key component to a decentralized stablecoin is confidence.
Once the confidence in UST dissipated, chaos ensued. It will be hard to rebuild the trust in Terra after the extent of reputational damage suffered and it brings back a pertinent point that stablecoins should be collateralized and credible rather than algorithmic and high yielding.
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