Why did Stable Coin UST go in Free Fall?

The sudden collapse of Terra USD, commonly referred to as UST has stunned investors. As a stable coin, it fluctuated by just thousandths of a per cent in the past. But in a weekend bloodbath, UST went into a death spiral and wiped out 99% of its value.

The most prominent question bothering everyone is how did a stable coin suddenly become unstable?

For this, you’ll need to know how stable coins work. Those who fear losing their investment can convert their crypto to stable coins to minimize risks. Stable coins are nothing but cryptocurrencies pegged to stable assets like the U.S. dollar. They can be backed by other assets too, such as commodities like gold, oil, real estate or even a large reserve of Bitcoin.

Then there are algorithm-backed stable coins, like UST. Unlike other stable coins, UST is decentralized and runs on the Terra blockchain. It pegs its $1 value through algorithms to its partner coin Luna. You can exchange 1 UST for $1 worth of Luna. The algorithm maintains an equilibrium, where it burns one coin to keep the other stable and vice versa.

So how did UST lose its $1 peg?

Over the weekend, the UST fell below $1. Of course, this was not the first time it fell below the $1 peg. The algorithm gives an opportunity for arbitrage, where investors profit by trading UST at a lower price for a dollar’s worth of Luna. This had been the norm for some time, but this time it was different.

Massive sales running in billions destabilized Luna. This included a massive withdrawal of $2 billion by Anchor Protocol, which houses most of the UST in circulation. This induced a massive sellout of Luna, whose value has essentially reduced to zero now. Many trading platforms have delisted both coins from their network.

Some believe it was a coordinated attack on the UST. Do Kwon, founder of Terraform Labs, had tweeted," Men will literally attack a stable coin unsuccessfully instead of going to therapy,” further strengthening speculations that it was indeed an attack.

Experts however say that the crash is because of the flawed algorithm, which leaves a lot of room for exploitation, unlike other stable coins which are really backed by the current value of the US dollar all over the world. The ripple effect of the decentralized nature of the UST has been a pointer to all stable coin projects that only being backed by a real currency can guarantee their stability.

Is UST expected to recover soon?

Most stable coins usually depend on real fiat reserves and backing from either a currency or valuable materials like gold.

So what backs the UST? Apart from the algorithm, the UST has a large Bitcoin reserve running into billions of dollars. There are, however, speculations that the UST might need to sell off its Bitcoin worth billions of dollars to regain its $1 peg. However, selling Bitcoin in the recent bearish market trend would further destabilize the crypto and its value.

Do Kwon in a statement, has proposed a plan to 'reconstitute the chain to preserve the community and the developer ecosystem.' This includes the distribution of 1B tokens:

  • 400M (40%) to Luna holders before the de-pegging event.
  • 400M (40%) to UST holders pro-rata at the time of the new network upgrade.
  • 100M (10%) to Luna holders at the final moment of the chain halt.
  • 100M (10%) to the Community Pool to fund future development.

Do Kwon also tweeted that the company would deploy more capital and adjust UST’s mechanism so it can be collateralised rather than just relying on the algorithm.

Not so Stable Coins?

The implosion of TerraUSD has put the future of all stable coins under a lens.

As the name suggests, stable coins are secure digital assets pegged to the price of another 'stable' asset and maintain the same value as their peg. They are like the bank accounts of cryptoland, designed to keep investments stable in times of market volatility. With a dollar peg, a stable coin should always be valued at $1.

The true mettle of a stable coin though is proved in the times of market stress and whether it can withstand the effect of investor panic.

A look at what’s happening to tether shows it may not be so stable after all. The world’s biggest stable coin is slipping below the $1 peg and has raised speculations about its claimed dollar reserves. If it continues to lose its dollar peg for a long period, it could potentially destabilise the crypto market.

So while UST’s flawed system may have caused its downfall, in the case of tether, panic selling and loss of market confidence could be a reason for its dip.

As a lot of crypto coins are losing their value amid a domino effect, there are talks of bringing in regulations for stable coins to protect investors. Till that time — HODL!