Infusion of $3.5bn not enough to revive Terra's 'stablecoin'

Estimated $42bn vanished with collapse of UST, Luna – we explain what all this means


TerraUSD, a so-called "stablecoin," has seen its value drop from $1 apiece a week ago to about $0.09 on Monday, demonstrating not all that much stability.

The cryptocurrency token, abbreviated UST, is supposed to be pegged to the price of the US dollar. Hence the "stable" terminology.

But UST is not a "centralized stablecoin" that's exchangeable for a fiat currency; UST for USD (US dollars). Rather, it's a "decentralized stablecoin," meaning it can be exchanged for Luna (LUNA) tokens, another cryptocurrency tied to the Terra blockchain.

UST and Luna are linked by an algorithm in a "smart contract" that's supposed to keep the value of the UST pegged to 1 USD without fiat currency reserves. The algorithm burns or deletes Luna tokens to create new UST tokens and vice versa in an effort to balance supply and demand.

"The Terra protocol uses the basic market forces of supply and demand to maintain the price of Terra," the Terra documentation explained.

"When the demand for Terra is high and the supply is limited, the price of Terra increases. When the demand for Terra is low and the supply is too large, the price of Terra decreases. The protocol ensures the supply and demand of Terra is always balanced, leading to a stable price."

This creates arbitrage opportunities – the ability to profit from price differentials – because Terra's protocol is set up so that users can always trade 1 USD worth of Luna for 1 UST. And if you're involved in the unregulated world of decentralized finance, that's the point of trusting your money to someone's programming code – profit.

Weak link in the chain

The complicating factor here appears to have been Anchor, one of the three main protocols in the Terra ecosystem. Anchor's creators describe it [PDF] as the "gold standard for passive income on the blockchain." It's a savings protocol that at one point paid participants close to 20 percent interest on their investment.

Unsurprisingly, that exorbitant interest rate appealed to people and drove demand for UST to deposit in Anchor. As of about three weeks ago, about 12.67bn UST had been deposited in Anchor, according to Decrypt, which at the time accounted for about 72 percent of all UST.

On Saturday, May 7, about $2bn in UST was unstaked – made available for trading – from the Anchor protocol and hundreds of millions of UST were sold. This has been described as an attempt to manipulate DeFi token prices for profit, though it might simply reflect recent market volatility or an exodus from Anchor as an oversupply of lenders drove the interest rate down.

Whatever the rationale, the price of UST declined, so investors tried to trade for Luna but the algorithmic system is constrained in the amount of UST or Luna that can be burned or minted, and the Terra blockchain also can only handle so much activity. Eventually, the system was overwhelmed by panic selling and the prices of both tokens plummeted.

Last week, the Luna Foundation Guard (LFG), a fund established by Terra creator Do Kwon, bought $3.5bn in Bitcoin to prop up its Terra tokens. But that fund is now largely depleted and the UST has not recovered – it's exchangeable for about $0.09 – and Luna tokens are worth even less, about $0.000193 from about $120 in April. All told, the coin collapse has erased about $42bn from the Terra ecosystem.

On Monday, in a series of tweets, the LFG said only 313 of its roughly 80,000 Bitcoins remain, the majority of which appear to have gone to large investors.

Small investors can look forward to being reimbursed with this remainder, or so the LFG suggests.

"The foundation is looking to use its remaining assets to compensate remaining users of $UST, smallest holders first," the tweet series concluded. "We are still debating through various distribution methods, updates to follow soon." ®

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