Why is UST Depegging and Terra Declining?

Today, the UST stablecoin saw a 26% drop in value to a low of near 70 cents, and Terra has seen a staggering 53% drop in value over the past 24 hours. The UST stablecoin is essentially seeing a run on the bank and is unable to keep its algorithmically-stable peg. If the Terra Foundation or venture capital firms do not bail out the Terra ecosystem, it will be one of the biggest failures in cryptocurrency history. 

Terra and UST aim to solve one of the biggest problems facing stablecoins: collateralization. Centralized stablecoins, like USDC, USDT, and BUSD, are backed 1:1 by dollars in a bank account and held by a centralized organization. Though this seems like an elegant solution to representing the dollar on the blockchain, there are a few problems with this approach. First, the centralized entity behind the stablecoin can effectively act as a bank and censor or blacklist certain users from interacting with their stablecoin, or even freeze funds in their account. This makes them no better than PayPal, Venmo, or any other centralized payment processor. Second, even though they may claim to fully back their stablecoin with real money, there is little transparency from some of these companies about their assets. Tether, for example, has been under scrutiny for several years for not fully collateralizing USDT and holding junk bonds instead of real dollars. 

In an effort to combat these issues, decentralized stablecoins were created. These coins, like DAI, collateralize themselves with cryptocurrencies like Bitcoin and Ethereum. This, of course, brings up an issue related to volatility, since cryptocurrencies are constantly changing value. Thus, to mint $1 of DAI, a user has to lock significantly more, close to $1.50, to prevent DAI from becoming undercollateralized in the case that the price of the underlying cryptocurrencies declines. This is quite capital inefficient, and Terra hoped to create a better solution.

UST is a decentralized algorithmic stablecoin, which means it is not backed 1:1 by US dollars. It uses the LUNA coin as its stabilization method. UST can be minted by burning LUNA, and burning $1 of LUNA always mints 1 UST, and burning 1 UST will mint $1 worth of LUNA. This ties the two coins together and, in an ideal world, means that as long as LUNA has value, the UST coin will keep its peg due to the arbitrage opportunity available at any given time. There are other incentive mechanisms in place to help keep the peg, but they are too complex for this short overview.

The LUNA coin is also the native asset of the Terra blockchain, which hosts popular financial dApps like Mirror Protocol and Anchor Protocol. 

UST has seen massive adoption over the past few months and rose to become a top 10 crypto alongside LUNA with a market cap of $20 billion. 

In January 2022, the Luna Foundation Guard, or LFG, was created to increase adoption of UST and quell concerns about its lack of a true backing. They created a UST reserve, which they hoped to use to help ensure UST maintained its peg in the event of a depegging. In early May, they had a total of $3.5 billion in Bitcoin, making it one of the biggest Bitcoin holders in the world according to CNBC. Some critics of UST saw this as an attempt to retroactively collateralize UST with Bitcoin, and thought it made UST less valuable since they were essentially admitting that an algorithmic stablecoin could not be fully uncollateralized. 

In the first weeks of May, the cryptocurrency market, along with markets around the world, faced a steep decline. This led to a selloff of both LUNA and UST, causing UST’s peg to begin to become unstable. This forced LFG to liquidate all of their Bitcoin to try and keep the peg alive. However, since Bitcoin has been decreasing, the value of their collateral is decreasing, and will continue to decrease as the selling of billions of dollars in Bitcoin creates lots of sell pressure. At the time of writing, not all of the Bitcoin has been sold to buy UST, but it appears that the LFG is moving in that direction.

Presently, UST is trading around 74 cents. It is unknown whether or not the Bitcoin from LFG will be enough to re-establish the peg at a dollar, or if more money will be needed from venture capital firms and other investors to potentially save the coin. Additionally, since LUNA is directly tied to UST, it is also facing massive price decreases and is now around the $30 level. Presently, there is a lot of pessimism in the cryptocurrency community about UST’s ability to recover, but it is still a possibility. Regardless of the end result, the cryptocurrency ecosystem will use this lesson to become more resilient and mass-market-ready in the future.

By Lincoln Murr

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