The Terra(UST) Stablecoin crash resulted in huge losses among crypto investors, leading to widespread fear and panic across the crypto community. The bitcoin-pegged stablecoins dropped to unprecedented lows, wiping off assets worth billions. The failure of this mechanism leads to questions regarding the stability of pegged stablecoins. Regulators across the US and UK voiced their concerns following the collapse.
What is Stablecoin?
Stablecoins are designed to have lower fluctuations in valuation compared to other cryptocurrencies. Their prices are pegged to currency/commodities such as USD, and the supply is regulated by an algorithm. Euro, or Won. Their supply is regulated by distinct crypto algorithms.
Stablecoins are largely used throughout the crypto community as a means to exchange their assets bypassing the need for intermediary banks for approving deposits and withdrawals. They are integral for powering the entire Decentralized Finance(DeFi) ecosystem. Another prominent use-case scenario is the use of stablecoins by citizens in nations plagued by hyperinflation.
The five most popular stablecoins- Tether(USDT), Binance USD(BUSD), USD Coin(USDC), Dai(DAI), and UST collectively represent approximately US$160 billion in value. All of the aforementioned stablecoins are centralized and collateralized. The entities in charge of these tokens keep a treasury of currency to back their valuation. DAI and UST use crypto assets as collateral but in different methods.
The US Terra mechanism is quite distinct from the other stable coins mechanisms, even different from DAI. Unlike DAI which collateralized a diverse crypto portfolio, UST does not feature any collateral and is a Terra-protocol-powered algorithm stable coin. The asset is backed by the LUNA token.
Once the UST’s price exceeds $1, the Terra protocol offers incentives to the users for burning LUNA and creating/minting UST. In the reverse scenario i.e. UST<$1, the protocol offers the opposite incentive- destroy UST and create LUNA. While the mechanism seemed ingenious and functional, the sudden halt of its operations bewildered many across the world. UST dropped from $1 to a mere 11 cents. Meanwhile, LUNA looked way worse.
What Really Happened?
Contrary to popular opinion, the mechanism did not actually fail. It worked as per its designs and issued LUNA according to the protocol in a bid to algorithmically return UST back to its predetermined $1 valuation. But, the valuations of LUNA were also dropping simultaneously.
Within a week between May 5 and 13, the total LUNA supply increased from 725 million tokens to a whopping 7 trillion while losing 99.9% of its valuation. This led to hyperinflation.
The parent organization Terraform Labs had scheduled a plan to purchase $10 billion in Bitcoin and other digital assets through LFG. The plan was to keep a reserve back in case an event such as this occurred. The main issue was the non-collateralization of UST, unlike the other stablecoins. Its market capitalization had soared to $18 billion, while the reserve remained at $4 billion. Despite lending out the reserves stored in the LFG, the Terra algorithm failed to bring the USD valuations back to $1. This led to a loss of $40 billion among UST and LUNA.
The Luna Reserve
The Luna Foundation Guard had acquired around 80394 BTC valued then at USD 3.5 billion to safeguard the growth and promotion of the Terra environment. The purchase occurred between January and May this year, and LFG started disposing of its BTC reserves to buy UST as its prices began to drop. Terra creator Do Kwon later clarified that the BTC would be utilized for trading purposes.
Around 22,189 BTC with an estimated worth of USD 750 million was transferred from LFG to a new address, in line with the Foundation’s announcement of loaning its bitcoin reserve to OTC trading enterprises for preserving the UST peg. A further 30000 BTC(~ USD 930 million) was resent to the same wallet address from other wallets belonging to the LFG on the same evening. The entire 52,189 BTC were then moved to a single crypto wallet through multiple transactions as per Elliptic- a blockchain analytics firm. The remaining 28,205 BTC in reserves were then transferred in entirety to another crypto account the following day on May 10. It is however not possible to determine whether either of the amounts was used to support UST valuations.
The US Terra has demonstrated the failure of crypto-backed reserves at present. This in turn was reflected in the crypto markets in the present days, leading to valuation drops in non-pegged digital assets as well, though they have already started their recovery.