What happened?

UST, an algorithmic stablecoin created by Terraform Labs intended to remain pegged to the US dollar collapsed over 90% over the past week. Terraform Lab's Luna token also saw a dramatic crash. Before the depeg, Luna was trading at $85. Trading at over $116 in April, Luna is now worth a fraction of a cent. The devastating effects of the crash were felt across the crypto markets. Some might be tempted to interpret this as just the latest event in a larger trend in the cryptocurrency market. Both Bitcoin and Ethereum are at their lowest points since 2020, and many other cryptocurrencies are faring even worse. However, this time it's different.

What is a stable coin?

Before going further, it is important to understand stablecoins. A stablecoin is a cryptocurrency that's pegged to a more stable currency, typically fiat currencies such as the US dollar. This allows one to keep their money in crypto without fearing loss as at any time one can theoretically redeem their stable coin for the currency to which it is pegged. Stablecoins are an integral part of the larger DeFi ecosystem, designed as an instrument to hedge against volatility and serve as collateral for decentralized lending and borrowing. The biggest stablecoins are tether and USDC, both tied to the US dollar. Theoretically, 1,000 USDT can any time be exchanged for $1,000. 

What is an “algorithmic” stable coin ?

Most stable coins are backed by some asset. In the case of Circle’s USDC, the company claims to have $1 in reserves for every USDC token in circulation. Similarly for USDT, Tether claims to have $1 in reserves for every USDT token in circulation, though some doubt the legitimacy of these claims. UST did not function this way and instead of a backing had an algorithmic pairing with Terra’s Luna token. The pairing was designed so that 1 UST could always be exchanged for $1 worth of Luna and $1 worth of Luna could likewise always be exchanged for 1 UST.

How does UST work?

Luna is the native token of the Terra blockchain, and creating UST requires burning Luna. This deflationary protocol was meant to ensure Luna's long-term growth. As more people buy into UST, more luna would be burned, making the remaining luna supply more valuable. 

To entice traders to burn luna to create UST, Terraform Labs came up with the Anchor Protocol. Anchor Protocol offered 19.5% yield on staking UST. This was an almost too good to be true offer for investors. Instead of keeping your savings at a bank for a measly 0.06% interest rate, you could put your money in UST, where it would earn 325 times that! Before the depegging, over 70% of UST's circulating supply, (~$14 billion), was staked in the Anchor Protocol. Anchor protocol was advertised as a “risk free” way to earn, and as such many DeFi investors leveraged themselves further using various borrowing mechanisms including Magic Internet Money (MIM) to earn over 100% APY on UST.

Since 1 UST can always be exchanged for $1 worth of luna, if UST were to slip to 99 cents, traders could profit by buying UST and exchanging it for luna, profiting 1 cent per token. Buying pressure on UST thus drives the price up, and the burning of UST during the exchange decreases the supply, further driving price up.

What went wrong? 

On Saturday, May 7, over $2 billion worth of UST was unstaked, and hundreds of millions of that was immediately sold. Whether this was an intentional malicious attack on Terra's system is being debated. This selling pressure pushed the price of UST down to 91 cents. Traders naturally tried to take advantage of the sudden arbitrage opportunity, they could now exchange 1 UST (worth 90 cents) for $1 worth of luna. The algorithm stopped them; Theres a cap of 100 million UST that can be burned on any given day.

Due to immense sell pressure, UST could no longer retain its peg. Investors rushed to sell their UST as the value continued to slip, bouncing between 30 cents and 50 cents in the week following the initial depeg. As of the time this article was written UST has fallen to a low of under 18 cents.

So, why is this a big deal?

Cryptocurrencies are known for their volatility, and uncertain economic conditions are bringing down not just crypto, but the stock market as well. Why then is Luna’s crash getting so much attention? One reason is the scale. Such an implosion has never before been seen for something the size of Luna, which just last month had a market cap of over $40 billion. Over $15 billion in crypto value has been wiped out through Luna and UST alone. Much of UST’s circulating supply was also used as collateral for loans in the broader DeFi ecosystem, the depegging thus also resulted in billions of dollars of liquidations. Stablecoins are a necessary tool and play an important role in DeFi, so a failure of this scale also raises questions about the stability of other stablecoins.

What's next for Terraform Labs? 

While he probably never anticipated an event of this scale, Do Kwon, CEO of Terraform Labs, had created the Luna Foundation Guard, a consortium seeded with $2.3 billion in bitcoin reserves, to maintain the peg. If UST dipped below $1, bitcoin reserves would be sold and UST bought with the proceeds. If UST were to rise above $1, LFG would sell UST until it returned to $1.

Over the course of a day, on May 9, around $1.6 billion worth of bitcoin was sent from LFG's wallet to the Gemini exchange. Another $875 million was sent to Binance. These funds can no longer be traced on either Gemini or Binance. A day later Terra temporarily shut down their blockchain.

On Friday, Kwon proposed forking terra, essentially creating a new blockchain with a state identical to terra before the depegging event.