23 June 2022
2 min read
Stablecoin is an interesting crypto product. A stablecoin is meant to maintain its price at $1 compared to a particular Fiat currency like USD, EUR, or GBP. Their existence is meant for crypto-natives to get in & out of the dollar easily without requiring a bank’s approval for deposits and withdrawals. Most of the crypto trading volume is facilitated by stablecoins, on top of them empowering DeFi.
Some of the popular stablecoins in the market are USD coin (USDC), tether (USDT), dai (DAI), and binance USD (BUSD). Also, quite prominently, there was terraUSD (UST) in this category as well. They were the five biggest stablecoins, demonstrating roughly $160 billion in the crypto market. USDC, USDT, and BUSD are collateralized and issued by centralized institutions. These institutions possess a vast reserve of dollars supporting each coin, by which the holder can redeem it for $1 from the issuer.
UST was different as it did not have any collateral at all. It was an algorithmic stablecoin driven by the Terra protocol and supported by LUNA, a crypto token, to stay in symbiosis. When the price of UST surged (>$1), the protocol incentivized users to burn (destroy) LUNA and mint UST. When the price of UST toppled (<$1), the protocol incentivized users to burn UST and mint LUNA. This was a smart strategy. Simply put, if the demand for UST was high enough to surge its price to $1.01, the protocol minted some UST in exchange for burning some LUNA.
In May 2022, terraUSD (UST), which was supposed to stay at $1, was no longer at $1, and this situation was not good because, on top of that, the value of LUNA, its backup, was also falling. On May 7, the price of UST, the $18-billion market cap algorithmic stablecoin, which was supposed to maintain a $1 mark, began to wobble and fell to 35 cents within two days. Moreover, its associate token, LUNA, which aimed to balance the price of UST, fell from $80 to a few cents on May 12. On this date, the prices of LUNA fell 96% in a single day, pushing it to less than 10 cents, along with the official halt of Terra blockchain, for the first time, at block height 7603700, putting the network’s security at peril. Since UST plunged under $1, all endeavors to recall UST to $1 failed, both by the Terra protocol algorithm and by the lending out of LFG reserves to trading firms, and as a result, Terra’s decentralized finance applications incinerated $28 billion as a majority of investors left the Terra ecosystem. The collapse of TerraUSD stablecoin threatened the entire crypto ecosystem.
Naturally, you’d assume that the mechanism malfunctioned, but it didn’t. It functioned as designed, which can be proved by looking at the amount of LUNA issued as the protocol tried to algorithmically bring UST back to $1 while LUNA’s price was also sinking. Hence, Terra’s odyssey from the underdog phase, as a South Korean payments app, to a $60 billion crypto-ecosystem concluded as one of the biggest failures in crypto.
At its peak, terraUSD (UST) was the third-largest stablecoin. Honestly, UST was a wild success in the crypto market, until the moment it was not. Now, what was the exact reason for this downfall, does not matter much, but what matters is that in adverse situations, Terra broke down completely, which was disastrous. This event supports the hypothesis that an undercollateralized, algorithmic stablecoin can depeg and lose significant value.