The crypto market has been a bloodbath over the last two days. Bitcoin dropped down to levels sub-30K, an 11% drop from its 38-39K stance, which it had been trading sideways at since March. More shockingly, however, the Terra algorithmic stablecoins UST (pegged to the US dollar) and counterpart LUNA, both plunged when the crypto market began to liquidate.
Stablecoins should accurately match the asset they’re tied to, as they act as an intermediate of value for people to trade the asset for the stablecoin in order to access other cryptocurrencies. Terra is an algorithmic-based stablecoin, yet it dropped a disastrous 98% in the last 24 hours, falling from a $32 billion market cap just 30 days ago to as far down as a humbling $540 million market cap. An extraordinary loss to say the least. The UST counterpart dropped an additional 56%. So why is this?
Under Collateralization
The main reason for these two stablecoins crashing is the bold risk of under collateralizing. Undercollateralized means
“The amount by which the outstanding principal balance of all insured obligations relating to such a transaction exceeds the outstanding principal balance of the collateral securing all such insured obligations.”
Essentially, the algorithm for LUNA and UST was over leveraged. Each time one LUNA token is minted, it needs to be balanced by one UST token being burned, and vice versa, in order to maintain UST’s pegging to the US dollar. The algorithm maintains a balance between the supply of each by incentivizing users to exchange in return for more of the other coin. These extra bonuses come from the reserves. So where did this go wrong?
Fundamental problems
LUNA and UST ascended to success in the crypto space by offering incredible staking rewards for use of their stablecoins. This was achieved through their new concept of algorithmic stablecoins. The issue was caused when LUNA and UST entered uncharted territory. They weren’t honest up front with the long term sustainability. As the market dipped and began trending sideways for months on end, the Terra algorithm began to struggle in capacity. They had:
Unsustainable amounts of rewards.
Depleting funding from their reserve.
Lack of liquidity.
LUNA and UST couldn’t create coins out of thin air, as it would instantly diminish their coin supply value, as well as their credibility. Instead, the team decided UST would be backed by an additional $1.5 billion Bitcoin, added directly to their reserve pool. The reserve pool is there for leverage and to back up either currency if required.
How LUNA & UST spiraled out of control
In buying such a huge amount of Bitcoin, Terra created a push-pull effect in the market, pushing up the price of Bitcoin, and in turn Bitcoin pulled the entire market up with it, as it accounts for around 40% of the entire crypto market alone.
This sudden change in the Terra ecosystem contributed to an overcorrection and depegged UST from the US dollar for a short period of time, causing confusion and uncertainty amongst Terra holders.
Before UST had a chance to stabilize, Bitcoin dropped in price just days later, dragging the whole market back down with it. This destabilized UST once again, spreading fear across the stablecoin holders.
The characteristics of a market crash show an influx into stablecoins. This is because they maintain their price, providing a safe haven during market woes.
Yet in this scenario, hundreds of millions of dollars began exiting their UST positions. Whether by planned strike or distrust over the stablecoins volatility, a mass exit from a stablecoin during a Bitcoin crash was certainly a disastrous scenario, and people were fleeing UST and LUNA. This skewed UST’s peg to the US dollar even further, becoming separated by more than 15% from the 1:1 ratio level with the dollar it was supposed to be kept at. The increased exiting from UST put Terra in a hole they couldn’t dig out of.
What happened next?
Dramatic burning of UST tokens which means a dramatic increase in users minting LUNA in order to exit.
This ensues a heavy increase of supply for LUNA while the demand decreases due to the market falling, significantly reducing its value and causing it to fall as well.
In an attempt to save UST from losing all of its liquidity, Terra sells a vast amount of its Bitcoin to prop up the price of UST.
This causes Bitcoin to dip further, and from there crashes the entire market heavier, causing more detrimental damage to LUNA and UST.
This downward market spiral continued, sending the entire crypto space led by LUNA and UST into complete chaos, with no genuine solution to save the Terra coins from utterly destroying themselves.
The founder of Terra – Do Kwong – began asking the community for solutions, further displaying their lack of preparation for market fluctuation and failure to calculate for situations that must be accounted for.
Don’t expect smooth sailing in crypto.
People sometimes fail to realize just how new some of these concepts are in cryptocurrency. It really is the wild west of investing. With a lack of rules and regulations, a basis on the future rather than now, and only a handful of years of analytical data, expecting a smooth ride to making money is anything but realistic.