A Week of Terra: The UST & LUNA Collapse
LUNA lost 99.99% of its value in a matter of days. Terra Protocol and its two main tokens — UST and LUNA — went into cascading domino-like freefall as the (supposedly) carefully constructed protocol failed spectacularly.
It’s important to know about UST and LUNA’s relationship in the Terra ecosystem to understand the unwind. UST is a stable coin but unlike USDT (Tether) or USDC, it’s not backed by cash, short-term US govt. securities, or commercially. UST is, at its basic level, an algorithmic stable coin. It’s supposed to maintain its peg to the USD through an intricate system of financial engineering by design.
Terra is different because it uses an arbitrage function to maintain UST’s peg. The protocol has two pools: a LUNA pool and a UST pool. Each can be traded with the other. Meaning, that 1 UST can always be traded for $1 worth of LUNA.
Now if UST were to lose its peg and drop below $0.99, traders could trade a large quantity of it for LUNA worth $1 each, and earn a profit of $0.01 on every token traded. Traded UST would get burned which further reduced the supply and increased its price to $1.
Alternately, if UST’s value would rise above $1.01, traders could trade LUNA to create UST and earn a profit of $0.01 on every token traded. The UST supply would increase and the price would drop to $1 again. In addition, traded LUNA would get burned which would make it more valuable.
Finally, to incentivize traders to burn their LUNA and create UST, Terra was offering an insane 19.5% yield on UST staking through the Anchor Protocol. Before the crash — over 70% of UST’s circulating supply was staked in this protocol — OUCH!
Protecting the peg further, Terra founder Do Kwon created what was called the LFG, a non-profit that held a reserve fund of around $3 billion in BTC and other cryptos. LFG’s job was to keep UST from dipping below $1, and it would use its reserves to buy tokens and restore its peg.
If UST rose, they would sell some UST and bring it back to $1, the profit was used to replenish its reserves.
In theoretical terms, this all sounds very good.
The cataclysmic downtrend started on May 7–8 and started to take a shit on Monday, May 9. Over $2 billion of UST was unstaked from Anchor Protocol and hundreds of millions were sold in a flash.
The titanic selling volume pushed UST’s price down to $0.91. Of course, traders rushed to buy the dip, trading $0.9 worth of UST for $1 worth of LUNA. But there was a huge problem! Only $100 million in UST can be burned for LUNA per day as designed by the protocol.
This resulted in UST not being able to retain its peg, investors flocked to sell their stock, and it drove prices down even further. This had a domino effect on the entire ecosystem and LUNA went to hell.
LFG quickly exhausted most of its reserves by trying to restore UST’s peg. Over $1 billion in BTC was sold, which triggered a MASSIVE sell-off and affected the entire crypto market. Billions of dollars in crypto value vanished within a few days.
So, what is next for Terra and UST? At this moment, the future of the faltering protocol and its stablecoin appears to be bleak. Liquidity in the Curve UST-3pool has largely dried up, limiting on-chain users’ ability to perform arbitrage transactions that would assist keeping the UST pegged.
Overall, the failure of the Terra protocol and UST will be remembered as one of the most significant events in crypto history. Never before has a stablecoin collapsed so dramatically after achieving such a large market cap and prominence in the crypto community.