An $18 billion algorithmic stablecoin lost its peg, how Terra Luna and its stablecoin, UST, came crashing to the ground. The Terra environment is currently in a state of chaos. Nearly everybody, including investors and traders to founders and developers, is baffled. Well, what happened to Terra Luna? In this article, we will explain why Terra red flagged and how we might avoid a similar death spiral. 

What Is Terra Luna (LUNA), UST?

Daniel Shin and Do Kwon founded Terra in January 2018. Terra’s native coin is the LUNA token, which serves as a governance, mining incentive, and volatility buffer. Terra has a number of algorithmic stablecoins, including UST, that are pegged to the LUNA token. They added a lot of products in the three years since their launch, including their algorithmic stablecoin UST. It believes that a decentralized environment necessitates the use of a native decentralized currency and is on a goal to replace centralized stablecoins such as USDT and USDC. Terra’s objective is for UST to become the de facto stablecoin in the crypto world, as well as in conventional e-commerce. 

What Exactly Is An Algorithmic Stablecoin? How Does It Work?

Rather than backing the price with assets such as real USD in a bank account or treasury securities, algorithmic stablecoins utilize market incentives regulated by algorithms to maintain a stable price versus a currency such as the US dollar. There are numerous types of algorithmic stablecoins on the market; some are partially backed by real assets, while others are created completely out of thin air. 

But how does it work?

You can’t simply create a coin out of thin air and state that it has the exact value as one actual USD So how is the peg maintained? LUNA is a fluctuating crypto asset, whereas UST is a fixed asset that, in theory, should always be redeemed for $1 USD. The token LUNA and the stablecoin UST are in a reflexive connection (One must go up in order for the other to fall down). This procedure should be explained right away.

• To mint (create a new token ) 1 UST, LUNA worth $1 must be burnt (destroy token).

• To redeem 1 UST, LUNA worth $1 must be minted.

• In short, every UST generated burns $1 worth of LUNA, and every UST destroyed mints $1 worth of LUNA. 

• This is fundamentally how UST keeps the peg.

Let’s take a quick look at circumstances where UST is greater than $1 and less than$1.

UST Expansion: If demand leads the market price of UST >$1, arbitrageurs may burn $1 of LUNA to mint 1 UST, which may then be sold in the market for a higher price than the peg, making a riskless profit. Market selling pulls the UST price back to its $1 peg, whereas minting increases UST supply. This procedure reduces the LUNA supply, which adds value to Luna holders.

UST Contraction: If desire drives the market price of UST <$1, arbitrageurs can acquire UST at market and redeem it for newly minted LUNA at par value (that is $1). Market buying restores the UST price to its $1 peg, whereas redemptions contract UST supply. This method raises the supply of LUNA, which is value dilutive to LUNA holders. 

Anchor is a Terra-based saving protocol that promises a 20% yield on UST. The “Anchor yield” as well as the “Anchor yield guarantee” are common terms for it. A big section of the UST user base is not investing in UST speculatively, but rather actually saving with it. The trust is kept as long as market participants agree that 1 UST is redeemable for 1 USD, and a big fraction of believers just cannot pass up that juicy 20 percent “risk-free” yield. People expected the algorithmic stablecoin to retain its peg and provide a risk-free 20% yield.

How All Of Suddenly The 20% “Risk-free” Yield Becomes So Risky?

It is essentially a conventional bank run since people began converting their UST to USD in large numbers yet received ever-lower rates for it. As people’s faith was rattled, more people began to convert their UST to USD, and LUNA entered a death spiral. As of the 11th of May, you only could acquire $30,000 in real USD for $100,000 in UST, effectively breaking the peg to 30 cents on the dollar.

How Will The Collapse Of LUNA And The Depeg Of The US Impact The Broader Market?

The Luna Foundation Guard (“LFG”) was formed in January 2022 with the primary mission of buttressing the UST peg’s stability. To do this, the non-profit added other assets to its treasury, including Bitcoin (BTC) and Avalanche (AVAX), with the purpose of using them as a backstop in the event the UST peg broke. LFG had 80,000 Bitcoin (US $3.2 billion) in reserves as of May 8th to defend the peg. This was a systemic risk for the market because investors were concerned about the impact of selling billions of dollars of Bitcoin into thin liquidity and low sentiment would have on the price of Bitcoin.

Two days later, on May 10th, US $3.2 billion in Bitcoin was drained in unsuccessful attempts to keep the peg. Bitcoin’s price fell, but not as much as investors expected. The bulk of UST investors utilized the algorithmic stablecoin solely for savings within the Terra environment, and analysis indicates that the spillover to the larger decentralized finance (DeFi) ecosystem is currently minimal. We feel that, with the elimination of Bitcoin from the LFG reserves, the systemic risks to the wider market pertaining to LUNA and UST are now low.

This article is not intended to provide financial product advice. Prior to actually making any financial decisions, you should consider seeking independent advice.