Terraform Labs designed the TerraUSD (UST) digital token to be a stablecoin with the value of each UST token pegged to one US Dollar (USD or $)1. However, on 9 May 2022, UST became “depegged” and, within 48 hours, lost almost 70% of its value. UST’s price continued to fall and, as of 6 June 2022,is about $0.016. UST’s sister token, LUNA, has dropped from its all-time high in April 2022 of $119 to just $0.00008. How could $60 billion of market value be destroyed so quickly?
Most stablecoins pegged to fiat currencies are backed by are serve of the currency to which they are pegged and investments denominated in that currency. The manager of the reserve issues stablecoins when users deposit fiat currency into the reserve and pay fiat currency from the reserve when holders redeem stablecoins.
For example, Gemini, the issuer of the Gemini Dollar (GUSD) token, explains that “[e]ach GUSD corresponds to a U.S. dollar held by Gemini in accounts at U.S. FDIC-insured bank accounts and money market funds holding short-term U.S. treasury bonds and maintained at a custodian.” Gemini also promises that “Gemini customers can redeem a GUSD for $1 at Gemini.”
In essence, the value of the GUSD token is stable because the value of the reserve is stable and because holders of GUSD tokens can exchange them on a one-for-one basis for USD with the issuer.
In contrast, the UST token is a type of stablecoin called an “algorithmic stablecoin”. The peg for an algorithmic stablecoin is maintained by an algorithm, or formula, that seeks to stabilise the token’s price by managing the supply and demand for it. The algorithm underlying UST sought to maintain the peg through a “mint/burn” mechanism in which minting one UST token required burning one USD worth of its sister token, LUNA, and vice versa.
The UST algorithm thus relied on ‘decentralised arbitrage incentives’ to maintain the peg, i.e., independent market participants converting LUNA tokens into UST tokens and vice versa. There was no issuer or reserve from which holders of UST tokens could redeem USD. Rather, LUNA tokens were intended to be ‘reserve tokens’ that would absorb the price volatility of UST tokens.
To illustrate how the UST algorithm was designed to work, when the price of one UST token is greater than one USD, there is an incentive to mint more UST tokens by burning LUNA tokens. Say the price of one UST token rises to $1.01; it is now possible to mint a new UST token by burning only $1.00 worth of LUNA tokens. This arbitrage opportunity continues until the supply of UST tokens has increased enough to cause the price of UST tokens to fall back to one USD.
Conversely, when the price of one UST token is less than one USD, there is an incentive to mint more LUNA tokens because $1.00 worth of LUNA tokens can be minted by burning one UST token with a value less than $1.00.This arbitrage opportunity continues until the supply of UST tokens has decreased enough to cause the price of UST tokens to rise back to one USD.
Every digital token needs a reason to exist, otherwise it will quickly fade to obscurity. To help generate external demand for UST, Terraform Labs launched Anchor, a lending platform that touted returns on UST deposits as high as 20%. Unsurprisingly, this led to explosive demand for UST and a skyrocketing price for LUNA, because burning LUNA was the only way to create more UST. The market capitalisation of both UST and LUNA spiralled upward, propelled in part by Anchor.
Unfortunately for holders of UST and LUNA, the good times did not last. The price of Bitcoin had been sliding steadily since early April 2022, but on 5 May began a precipitous decline that would see it plummet by a third in only a week. That decline was accompanied by a general selloff in the crypto markets, including LUNA.
In the midst of that decline, LUNA’s market cap fell below that of UST, reaching a ratio of just 0.5 on 10 May 2022 (it had been as high as 1.9 in April). Holders of UST were no longer assured of being able to redeem their tokens for $1.00 worth of LUNA and lost confidence in the peg. Thus began a death spiral of UST and LUNA, with each drop in value of one causing a further drop in the value of the other.
In early 2022, Terraform Labs began accumulating a reserve of Bitcoin to support the UST peg that would eventually be worth several billion USD. However, that reserve would not prove to be enough to stop the spiral that would cause the sharp decline of UST and LUNA.
Two leading theories have emerged to explain the crash of UST and LUNA. One is that an investor with an enormous short position in Bitcoin carried out a speculative attack, selling $350 million worth of UST to smash its peg, which in turn caused Terraform Labs to deplete its Bitcoin reserve and further depress the price of Bitcoin.
The other theory is that UST and LUNA crashed from the weight of their own economics. With no asset reserve and little demand for UST outside the Anchor platform, critics say the crash was inevitable. Others seethe crash as a classic bank run, when depositors seek to withdraw their entire balances all at once. As the founder of Terraform Labs said in an 11 May 2022 proposal to revise the UST algorithm, “[i]n extreme situations like this, Terra cannot save both UST peg, and save LUNA price at the same time.”
1 In late May 2022, Terraform Labs launched a new blockchain with the same branding as the original. Consequently, the original UST token has been renamed USTC (UST Classic) and the original LUNA token has been renamed LUNC. In this article, we will continue to refer to those tokens by their original names.