Why did the UST stablecoin collapse and what is the future of the Terra ecosystem?

The price of the UST collapses by almost 75%

In a few days, the ecosystem UST course Terra (LUNA) had a real nightmare. The stablecoin broke away from the dollar and first fell to $0.65before rising temporarily and falling back to a low point at $0.22, thereby shaking the entire cryptocurrency industry.

Figure 1: UST price against the US dollar

It may seem surprising, even counter-intuitive, but stablecoins can indeed break away from the currency to which they are supposed to be “peg”. At least some of them do. To understand this, one must understand the different categories of stablecoins.

Stablecoins such as USDT or USDC are pegged to the dollar price by being directly backed by a pool of tangible assets. Conversely, algorithmic stablecoins, like the UST, rely on an algorithm to maintain their indexation with the dollar.

To put it simply, the course of the UST is maintained thanks to an arbitration mechanism orchestrated by users. Concretely, when the price of UST decreases, it is possible to exchange 1 UST for 1 dollar of LUNA to reduce the total supply and increase its value until equilibrium. The phenomenon also applies in the other direction.

However, this strategy carries a major risk. In the case where a lot of UST would be sold in a very short time, the volumes would be such that the arbitrage would not have time to react and reverse the trend. And that is precisely what happened.

πŸ‘‰ To dive deeper, our complete guide to TerraUSD (UST), a decentralized and algorithmic stablecoin powered by LUNA

Concretely, why did the UST collapse?

UST and LUNA, an infernal spiral

In a few months, the UST managed to rise to the third position of stablecoins the most capitalized on the market. The main reason is Anchor, which was capturing so far 52% of the total quantity in circulation, or $10 billion. And for good reason, the protocol offers an annualized return of 19.5% for UST staking.

As the rewards were paid in UST, new coins were created daily. However, as explained above, 1 minted UST results in 1 burnt LUNA dollar. In other words, a constant upward pressure was imposed on it, which saw its price increase by 10 in the space of a few months.

You would have understood it, everything is fine as long as the market remains bullish. But obviously, this system has a counterpart and we have experienced it in recent days. At the end of last week, in a tense geopolitical context and following the announcements of the American Federal Reserve, the cryptocurrency market eventually gave way.

Like all altcoins, LUNA follows the fall of King Bitcoin (BTC). In Panic, UST Holders Exploit Arbitrage Mechanism and Burn UST to mint the equivalent in LUNA, which they sell immediately to cover up. This creates a double bearish pressure on the course of the LUNA which leads it inevitably towards the abyss.

UST de-indexes, safeties don’t work

We have all the ingredients for an explosive cocktail, ready to ignite at any time. The trigger came this weekend. A supposed attack targeting a liquidity pool on Curve Finance used $350 million of UST to drain cash, resulting in a first depeg from UST up to $0.97.

However, the arbitration mechanism jams and fails to correctly restore the indexation of the UST price. This is where the Luna Foundation Guard (LFG). Responsible for ensuring the security of the stablecoin, the foundation sold its reserves of bitcoins to buy back UST and try to raise the price.

As a reminder, since the beginning of 2022, the LFG has accumulated $2 billion worth of Bitcoin. to build up a safety reserve. In particular, it has teamed up with investment funds to buy bitcoins Over The Counter (OTC) in exchange for LUNA at a reduced price.

Unfortunately, the LFG’s strategy struggles to restore the course of the UST. Faced with a $20 billion capitalized stablecoin, the 2 billion in the reserve were not enough. Moreover, these bitcoins bought for $42,000 on average had already lost more than 15% of their value at the time of their forced sale.

Although 2 billion dollars of BTC sold may seem paltry compared to the 600 billion dollars of market capitalization of the first cryptocurrency on the market, the impact has been sufficient to induce panic.

Panic grips the market

It is a well-known fact that these are the emotions that dictate the state of the market cryptocurrencies. In the face of suspicions of attacks against the UST, its depeg of the price of the dollar and the failure of the security system of the stablecoin, it is the beginning with a huge wave of panic.

The users massively sell their UST, as evidenced by the total value locked on the Anchor protocol, which collapsed by 85% in just one week:

Anchor TVL drop

Figure 2: Total Value Locked (TVL) on Anchor

As a result, the price of UST continues to fall. The LFG security reserve is empty, as are the various Bitcoin wallets belonging to the Terra Foundation. There is no more security measures to hold the stablecoin, trust is totally lostpanic continues to hit the ecosystem.

Order books are empty

On the other hand, the situation on centralized exchanges is getting worse. Faced with panic selling, Binance decides temporarily block withdrawals in UST from its platform, adding fuel to the fire.

However, the exchange is taken by storm and the order book is completely empty : no more buy orders and no more possibility of selling its UST.

To understand this, you have to say that stablecoins do not work like other cryptocurrencies. If Bitcoin falls, there will always be buy orders placed at the old supports: $28,000, $20,000, and lower. For a stablecoin, this does not exist. Its price is located between two mountains of order volume around $1.

Once the UST price drops below the lower bound for buy order volumes, nothing more could hold the pricesince no buy order was set.

πŸ‘‰ To get back to the facts – Terra: UST stablecoin hits $0.22, LUNA loses -89% in 24 hours

What about the impact on the ecosystem?

The future of LUNA and UST

At this stage, it is practically impossible to determine to what extent the problems of Terra and its stablecoin UST are the result of the fall in the cryptocurrency market or to what extent they are the cause.

On May 10, after hitting a first low around $0.6, the UST managed to rise above $0.93. At the end of the day, the creator of Terra, Do Kwon, wanted to reassure the community: β€œClose to announcing a recovery plan for the UST. Hang on”.

However, we learn later that the Terra Foundation would have found an agreement with various investment funds to raise an additional $1.5 billion in order to restore the UST peg. In exchange, the half-price sale of LUNA tokens to investors.

The euphoria was only short-lived, the course of the UST relapses violently until reaching 0.22 dollars. For the moment, nothing indicates that it will be able to re-index itself to the dollar. Moreover, as long as the price of the UST remains lower than that of the dollar, LUNA price will continue to tumbleand this, because of the mechanism of burn and mint mentioned above.

All of DeFi impacted

Within 24 hours, the Terra blockchain lost 75% of its Total Value Locked (TVL). At the head of the bow, Anchor went from $18 billion to just $2.3 billion from TVL. The same for Mirror Protocol, whose MIR token fell by almost 60%, causing a lot of liquidation among users.

TVL Terra

Figure 3: Total Value Locked (TVL) on the Terra Blockchain

The downfall of the Terra ecosystem and its stablecoin UST represents a terrible threat to all of DeFi. The UST was branched out to many other ecosystems, through the “4pool” on the Curve Protocol in particular, including the loss of liquidity directly impacted some protocols such as Convex (CVX) or Frax (FXS).

Moreover, on Curve Protocol, the liquidity pools composed of USTs are being emptied. Regarding USDT-3Pool and USDT+3Crv wormhole v2 pools, transaction volumes are respectively 5 and 10 times greater than the liquidity that composes it.

Curvepool

Figure 4: Different pools on Curve Finance

In addition, the pools are absolutely not balanced anymore. This testifies of a capitulation of the users and a complete loss of confidence in UST’s ability to regain its peg.

The Terra community eagerly awaiting the news of its conductor, Do Kwon. Will UST and LUNA succeed in rebounding? What will be the future impacts on the DeFi ecosystem and the cryptocurrency market? Only the future will tell us.

πŸ‘‰ Learn more – Luna Foundation Guard (LFG) to loan $1.5 billion in Bitcoin (BTC) to keep UST stable

Sources: Figure 1: TradingView, Figure 2: DefiLlama, Figure 3: DefiLlama, Figure 4: Curve.fi

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About the Author : Lilian Aliaga

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Freelance writer located between Paris and Toulouse. I want to share my passion for the world of cryptocurrencies to as many people as possible. I am also interested in technical analysis and trading.
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