When a Stablecoin Isn’t So Stable, Terra and the Crash of UST

As the largest algorithmic stablecoin, TerraUSDs (UST) dramatic unravelling sends shock waves throughout the crypto markets.

Billions of dollars worth of digital assets vanished within the blink of an eye as the value of TerraUSD (UST) nosedived on Monday, 5/9/2022. The coin continued to fall over the week, where, with less than 700 million coins in circulation, it hit just above $0.13 on Friday, 5/13/2022. This epic crash now leaves investors, companies, and the investing industry as a whole, in stunned disbelief.

What is Stablecoin?

Cryptocurrency is known for its decentralized nature, its volatility, and in exchange, its vast gains. But even something volatile needs stability. Like traditional banking reserves, cryptocurrency requires mechanisms to utilize the balance of liabilities and assets to protect coins from volatility while maintaining and storing value.

Enter Terra – a stablecoin with a process that acted similarly to a central bank. As such, Terra possessed liabilities in the form of UST and countered with the assets of sister-coin, LUNA (the native token of the Luna blockchain). This central bank of Terra’s had one goal: keep UST pegged 1:1 with the dollar. It achieved this by using LUNA to stabilize the UST so that you could always trade 1 UST for $1 worth of LUNA. All of this while LUNA’s price was being monitored with an on-chain oracle, creating a self-sustaining ecosystem. In contrast, other popular stablecoins such as USD Coin (USDC - $50 billion market cap) and tether (USDT - over $80 billion market cap) use traditional collateral assets, such as fiat reserves and treasuries, and USD bank accounts.

Essentially, LUNA was the collateral for UST, and that relationship established USTs value. So, anytime UST fell below $1, an arbitrageur could buy the decreased price of UST for, let’s say, $.99 and then trade it back for $1 worth of LUNA, quickly return it to the peg.

What Makes Terra Different?

Before discussing its doomsday collapse, it is essential to talk about what made Terra unique in the world of stablecoins. The most crucial being that Terra is an algorithmic stablecoin. Instead of being backed by reserves, algorithmic stablecoins maintain their fiat peg without external collateral, using math and incentivized market participant behavior.

Terra is not the first algorithmic stablecoin, but it was the most well known. Its popularity exploded as one of the highest-performing assets of 2021, growing from $0.63 to $91.38 over the year, and by March 2022 surpassed Solana, becoming the most valuable alternative L1 behind Ethereum.

At the center of Terra’s massive growth was Anchor Protocol. Anchor was a simple money market that accepted UST and yield-generating assets – generally in the form of liquid staking derivatives. Staking derivatives passively generates a yield, which is then used to subsidize the top interest rate to stakeholders.

Anchor featured a fixed target yield of 20% for depositors, making it highly enticing and controversial. To achieve this, Anchor used on-chain reserves of UST to make the extra interest payments. In addition, Anchor's unwillingness to fluctuate its 20% fixed rate, even when DeFi yields were in broad decline, made it incredibly attractive to those whose goals were to grow their wealth as rapidly as possible.

What Happened to UST and LUNA?

UST started to deviate from the 1$ (hitting an inflection point on May 9th) as continued uncertainty surmounted and the concern about April’s inflation rates soared. In response, a few heavy hitters in the industry withdrew large amounts from Anchor and then pushed their UST through Curve – the industry’s largest on-chain DEX for UST. This rapid and voluminous sale of UST – approximately several hundred million – was enough to knock UST off its peg.

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While it is still only rumored, the presumptive consequences that particular financial industry leaders, BlackRock and Citadel Securities, were involved in the subsequent collapse of Terra is a vital analysis to examine, even if only in conjecture.

Using their sheer power of positioning, an asset management company like BlackRock (BLK) and Citadel Securities, in theory, have the ability to sway markets for self-interest. This sway could result in a catastrophic collapse of an asset, especially if that collapse creates favorable conditions for those powerful companies.

Following that theory, this move could propel the panic, as more Anchor users began to withdraw and sell their UST. They then redeemed it for LUNA and sold it for cash so quickly that LUNA slid from $22 billion to $11 billion in just a few hours, bypassing the 100% collateralization threshold. As a result, UST was suddenly under-collateralized.

The market reaction to all of this was violent. A full-on bank run ensued as Anchor depositors frantically scrambled for a way out. This rush caused a dramatic de-pegging that plummeted UST – Terra’s reign was over.

BlackRock denies the allegations, but as the world's biggest asset manager who manages Circle’s USDC cash reserves (USTs direct stablecoin competitor), it is possible to speculate that maybe the UST implosion was the result of an aggressive game of chess. We saw a similar outcome in the 2008 financial crisis when the Lehman Brothers filed for bankruptcy after being steered into subprime mortgages, packaging debt into bonds, and then selling them to investors.

It is not far-fetched to imagine how creating unstable conditions in the investment world could be opportunistic for powerful and wealthy companies. It makes it possible to short a stock or a coin and come out on top with billions more in their pocket.

Can Crypto Make a Comeback?

With the collapse of Terra, it is fair to wonder if there will ever be a successful algorithmic stablecoin. In theory, it is brilliant, a process that genuinely adheres to the decentralized ethos of cryptocurrency. But, of course, decentralization is a spectrum, so the tightening of regulations as a likely result of this seismic event is not inherently wrong, nor does it mean that the crypto intention is lost.

Terra’s implosion took the whole crypto market with it. Bitcoin dropped 20%, and altcoins fell 50% or more over a single week. Tens of billions of dollars in paper wealth vanished. Retail investors lost their savings, funds went bankrupt, and entrepreneurs were building on the blockchain. **
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The critical component to Terra’s dramatic end was ultimately due to Anchor and the guaranteed perennial 20% APY during times of collapsing yields. This strain on the reserves created an unstable relationship between UST and LUNA. It would show this outcome if inspected closely, even if it took most of the industry by complete surprise.

My advice to everyone, whether they are bullish investors, curious entrepreneurs, casual spectators, or just the average everyday person, is to learn more. Do more research and develop a deep comprehension of this industry, specifically which investments are the right place for your interests and finances. Be sure you diversify your investments to allow yourself space to weather any upset. There are legitimate crypto projects that will survive and even thrive in the wake of this crash.

Terra’s lesson about pursuing more at all costs has left everyone in a humbled state and the crypto industry reeling. But there is always a pause for reflection in the wake of a storm. So, take time to further your learning, stay strong in uncertain moments, continue to persevere, and trust that the industry will find its stability once again.