Unstable Stablecoins: What Exactly Happened with UST and LUNA

April showers bring May madness apparently.

This last week has been nothing short of traumatic for the cryptoverse, and stablecoins are at the centre of it, following the collapse of TerraUSD (UST) and LUNA.

On Monday, May 9, UST, a once $15 billion stablecoin, was depegged and plunged from its $1 peg to 30 cents. (1)

As of May 13, 2022, UST was essentially worthless at $0.00012 to the U.S. dollar (2), and trading for UST and LUNA is completely suspended in Binance for the time being. (3)

The price of UST to USD over the past 7 days

As a result of this, investor confidence in stablecoins—so-advertised as being “stable”—has understandably been shaken, with many calling UST and LUNA nothing more than a Ponzi scheme.

But before we dive in and explore what went down, let’s give a quick recap of what stablecoins are.

What stablecoins are and how they try to offer price stability

Like their name suggests, stablecoins are meant to provide the benefits of decentralization while being separated from the volatility of the cryptocurrency market. They’re envisioned as a best-of-both-worlds' offering that try to maintain price stability in one of three ways:

1. Backing their coin with fiat currency (e.g., the euro, the USD, etc.) or fiat-denominated assets,
2. Collateralizing their coin with other cryptocurrency, or
3. Using computer algorithms.

Some of the world’s biggest stablecoins, like USDC, are those backed by a fiat currency. These are known as off-chain collateralized stablecoins because they’re backed by real-world assets—usually the U.S. dollar. In the case of USDC, one USDC equals one 1 USD. This price remains stable because USDC’s issuer only mints as much USDC as they have actual USD in their bank reserves.

Okay, so what about UST and LUNA

UST works a bit differently: it’s an algorithmic stablecoin. It works with LUNA (the native coin for the Terra ecosystem) to maintain a one-to-one peg against the U.S. dollar through an algorithm.

LUNA is the reserve currency for UST and trades by supply and demand. UST was supposed to be “stable” in the sense that although the price of LUNA could fluctuate, you would always be able to trade one UST for $1 of LUNA, no matter the price of LUNA. (4) An algorithm (in this case, an automated smart contract) lets people swap the two currencies.

Essentially, this stablecoin tried to maintain price stability through market incentives using a burn-and-mint mechanism.

If UST was trading at $0.99, you could buy it and redeem it for $1 of LUNA and instantly profit. Likewise, if it was trading below $1, you could buy one UST for less than a dollar, trade it for LUNA, and yes, profit.

To maintain this symbiotic relationship and keep UST pegged at $1, one LUNA is burned for every UST, holding LUNA’s supply in check.

So that’s the basics of how these coins were meant to stay “stable,” but there’s one other crucial element to keep in mind, namely: the Anchor protocol (Anchor)—UST’s largest use case.

Anchor’s ambitious yield promise

Anchor is a decentralized savings protocol on the Terra blockchain. It was the largest decentralized app (DApp) on Terra by total value locked, with over $8 billion of cryptocurrency deposited into its savings protocol. (3)

Anchor promised that users could stake UST on its protocol and make an annual interest rate of about 20%. (3)

How was this type of yield possible? Well, spoiler alert: it wasn’t really. But initially it worked because of the interest earned from their borrowers, since borrowers needed to lock up large amounts of collateral on Anchor and pay over 10% of an annual percentage rate (APY) on their loans.

So that was the theory.

In practice, demand skyrocketed (of course), and the 20% APY soon became unsustainable.

Users were just locking up UST on Anchor rather than using it in transactions. Better to just let it sit and earn this crazy yield.

Before the crash, the total supply of UST in circulation was around $18 billion, with over $10 billion locked in Anchor. (5)

Trying to fix the sustainability problem

Terra initially didn’t want to decrease Anchor’s yield, since that was the main reason to hold UST. So it formed the Luna Foundation Guard and recapitalized the Anchor yield reserve with 450 million UST to try to maintain the stablecoin’s peg.(6)

The Luna Foundation Guard also bought over $3.5 billion bitcoin as reserve to restore UST’s peg when needed. If UST ever fell below $0.98, BTC would be sold for UST to reduce UST’s market supply.

Even still, when it became clear this yield wasn’t sustainable, Terra passed
Proposal 20 in March that stated if Anchor’s reserves decreased by 5%, the interest rates would decrease. (7) The rate was also expected to drop each month if there were more lenders than borrowers, which was usually the case.

Once the high interest rate incentive was no longer there, UST holders began to remove their money from Anchor.

On Friday, May 6, there was roughly 14 billion UST in Anchor. By Sunday, there was 11.7 billion. (5)

Pinpointing the Franz Ferdinand of the collapse

Since in practice, people mainly held UST to take advantage of Anchor’s savings rate, once that was gone, they no longer had a use for UST.

To get rid of their UST, they could:

1. Swap it for $1 of LUNA, or
2. Exchange it for another stablecoin on a decentralized exchange like Curve Finance.

Mass minting of LUNA

Lots of people took option one and swapped their UST for LUNA, which led to an extreme drop in supply of UST and a giant glut in supply of LUNA.

Daily change in LUNA and UST Supply

This is because every time someone swapped and burned UST for LUNA, the algorithm meant that more LUNA was minted, which when done exponentially, like in this past week, completely dropped the value of the token. On the flip side, whenever you swap 1 UST for $1 of LUNA, you need more LUNA to hit $1 dollars, which means minting more, creating a vicious circle.

Stablecoin exchange starts extreme discounting

As for those who took the stablecoin exchange route. Well things got a bit unstable.

Since so many people were trading out their UST for other stablecoins, there was more UST than any other stablecoin in the pool. To keep things in balance, Curve Finance began offering discounts for UST. But remember without Anchor, even with the arbitrage opportunity provided by the discounts, people seemed to view UST as entirely useless so were not taking it.

Then, on May 7, a crypto whale hit the waters and traded more than 85 million UST tokens for 84.5 million USDC and things got really off balance.

The next day, another whale dumped 285 million UST onto Curve and Binance. Immediately after, it’s speculated that people started shorting LUNA en masse. (8)

UST was depegging, the price of LUNA was plunging, and because of the interconnectedness of the cryptoverse, this started a domino effect, shaking investor confidence and affecting the price of Bitcoin and the like.

How did it affect Bitcoin?

Well, remember how the Luna Foundation Guard bought BTC reserves in case they needed to restore the UST peg? During all the madness, on May 9, they sold $750 million of their reserves, which led to a drop in Bitcoin to a low of about $30k that day.

Bitcoin’s price fluctuations last week

Lessons learned and moving forward

While the ramifications of this event are still playing out, and as we continue to get more information about how UST completely untethered to its U.S. dollar peg, it’s important to remember a few key things.

1. All stablecoins are not the same.
It’s easy to hear this story and say that all stablecoins are bad, or that all algorithmic stablecoins are flawed. But much like how Bitcoin and Ethereum are not the same, not all stablecoins are the same.

One of the most widely circulated videos in the last few days has been Nevin Freeman, the co-founder of the Reserve protocol, forecasting exactly what would happen with UST at the Latin American Bitcoin & Blockchain Conference in 2020.

And while he’s looking like an extremely smart guy right now, it might be too simplistic to say that algorithmic stablecoins don’t work. Rather than write off these assets in their entirety, this scenario has proven the value of lesson two.

2. Before investing in cryptocurrency, it’s important to do your homework.
It’s no secret that crypto is a new and volatile investment. It’s important to understand what a coin or token is before you invest in it and understand the risks and trade-offs of each investment.

An easy way to keep updated with crypto news and analysis is through our monthly newsletter, Notes from the Blockchain. You can subscribe here.

3. Understand a token’s use cases.
Arguably the fatal flaw of UST was that it only had one purpose—to be invested in Anchor’s high-interest savings protocol. This incentive, put in place to help UST gain scale, proved unsustainable. Once it was taken away, well, you know what happened…

One of the reasons we’re so excited about Ethereum is because of the limitless applications of the Ethereum network. There are many use cases by design, and we believe they will only continue to grow, but that is not the case for everything in the crypto universe.

We will be watching this story as it continues to develop. If you have any questions, or you’d like to discuss this further, please feel free to reach out.

— Vlad Tasevski, Chief Operating Officer and Head of Product at Purpose Investments

Sources:

1. https://www.cnbc.com/2022/05/12/cryptocurrency-luna-now-almost-worthless-after-ust-falls-below-peg.html
2. https://coinmarketcap.com/currencies/terra-luna/
3. https://www.binance.com/en/support/announcement/f68451879a1841a6a0f44025735d9236?ref=AZTKZ9XS&utmsource=BinanceTwitter&utmmedium=GlobalSocial&utmcampaign=GlobalSocial
4. https://docs.terra.money/docs/learn/protocol.html
5. https://cryptobriefing.com/a-beginners-guide-to-terras-defi-ecosystem/
6. https://beincrypto.com/luna-foundation-450m-cash-injection-boost-anchor-defi-reserves/
7. https://forum.anchorprotocol.com/t/dynamic-anchor-earn-rate/3042
8. https://u.today/285-million-ust-sold-by-single-wallet-on-curve-and-binance-triggers-huge-outflows

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