The trades that triggered the eventual collapse of the stablecoin TerraUSD

The crypto market has seen some serious swings over the past year. Bitcoin, arguably the flagship of the market, began to lose its value late last year after reaching historic highs, a trend that eased at the beginning of 2022. Until, that is, the meltdown of TerraUSD in May.

What was the market offering of TerraUSD?

TerraUSD (UST), a stablecoin that was pegged to the US dollar, crashed in a spectacular fashion earlier this year, reinforcing a sell-off mentality that was already in full swing among crypto investors and sending Bitcoin and other cryptocurrencies into a bit of a tailspin.

Stablecoins are, as the name suggests, a class of cryptocurrency that are designed to maintain a stable valuation. This differentiation is supposed to set them apart from those cryptocurrencies, Bitcoin included, that can see wild fluctuations in value that aren’t necessarily linked to external factors beyond people’s perception of the crypto themselves.

Some stablecoin issuers aim to achieve a dependable stability by keeping stores of assets, including cash or commodities, as a form of collateral to guarantee the value of their crypto. The goal is to ensure the stablecoin maintains, or remains close to, the value of its peg.

Other stablecoin issuers, however, attempt to maintain their stablecoin values in different, frequently more complicated, ways. Terraform Labs, the issuer of UST and its sister token, Luna, falls into the latter camp. To keep its crypto stable, Terraform Labs opted for an algorithmic approach. Algorithmic stablecoins are backed by nothing more than code. This type of stablecoin uses algorithms – a complex sequence of rules – to control money supply.

All crypto is based on code to some degree. With cryptographically linked blocks of digital transactions underpinning the distributed ledger system that keeps these digital currencies in check, code is an essential element to the very existence of crypto. But an algorithmic stablecoin extends the use of code as the basis of its stability rather than real assets.

Where did it all go wrong for TerraUSD?

In UST’s case, its 1:1 US dollar peg was maintained via a process in which Luna would be injected into, or withdrawn from, the market to absorb volatility and maintain stability. This ‘mint and burn’ process was controlled by algorithms, computer code. Essentially, ‘minting’ US$1 worth of UST could be accomplished by ‘burning’ US$1 worth of Luna, and vice versa.

Algorithmic stablecoins like UST are sometimes referred to as uncollateralised stablecoins. This is because they are not backed by, or tethered to, financial reserves like fiat currency or other assets like bonds. Those that are backed are called collateralised stablecoins, because they are associated with some kind of collateral that has a value independent of, and separate to, the perceived value of the cryptocurrency they are being used to back.

A third method sometimes used to maintain stablecoin value is referred to as over-collateralisation, where a large number of crypto tokens are held in reserve for the issue of a lesser volume and value of stablecoins. Over-collateralised stablecoins might be backed by greater holdings of Bitcoin, for example, to provide a buffer against value fluctuations.

As an uncollateralised stablecoin, UST was always going to be exposed to certain risks that collateralised cryptocurrencies are not. However, it was thought that the algorithmic approach to shoring up the stability of the stablecoin’s value was effective enough for most of the potential risk to be discounted. This confidence might have been just a little misplaced.

It is likely that UST’s uncollateralised design made it more fragile. The latent fragility of UST is evident in the nexus of the stablecoin’s crash, which also toppled its sister token, Luna.

The downward spiral

The swift crash of UST began in early May, when Terraform Labs withdrew 150 million UST from 3pool, which is a decentralised stablecoin exchange. This withdrawal didn’t come as a surprise. It was part of a planned and public attempt to move the funds into another pool.

However, shifting the funds made the available UST stablecoin pool – which was already seeing an unusually low volume – shallower. This made the crypto much more prone to volatility. Waves break over shallow water. The same can be said about crypto volatility.

Less than a quarter of an hour after these funds were withdrawn from 3pool, a trader swapped 85 million UST for USDC, which is backed by the US dollar. In the next hour, another trader swapped 100 million UST for USDC, in four increments of 25 million UST at a time. Aware of the quick succession of large withdrawals, Terraform Labs attempted to ‘rebalance’ the ratio of UST to other stablecoin by withdrawing another 100 million UST from 3pool.

By the time this happened, the large trades had already impacted UST’s value, repeatedly breaking its peg to the US dollar. User confidence was also hit, with panicked investors selling off their holdings in UST. Many investors withdrew their funds from the UST ecosystem via their UST deposits in Anchor, a DeFi lending and borrowing protocol that promises to provide crypto investors a reliable interest rate of up to 19.5%. It is also operated by Terraform Labs.

Three unidentified UST traders swapped a combined US$480 million worth of USDT – an asset-backed stablecoin known as Tether – for UST over three days from 7 May, the day the quick succession of large trades initially hit the stability of the stablecoin’s peg. This action was taken by UST supporters to repair the peg and rebalance the stablecoins held in 3pool.

Further action was taken by the Luna Foundation Guard (LFG), a firm established to support the Terra ecosystem by building and holding reserves of various crypto with which to provide a backstop to UST’s peg. On 9 May, two days after the first big trades hit UST’s peg, the LFG swung into action, selling billions of dollars’ worth of Bitcoin holdings from its reserves.4

On 10 May, the Luna Foundation Guard’s reserves were depleted, and what it had pumped into the UST ecosystem failed to have a lasting effect, with UST once again losing its peg against the US dollar, this time for good. Meanwhile, UST’s sister token, Luna, quickly became hyperinflated after UST holders ‘burned’ the holdings en masse in an attempt to balance the value of the stablecoin, ‘minting’ an equivalent number of Luna tokens in the process.

With supply entering trillions, Luna prices tumbled. Just a month before the crash, Luna hit an all-time high of $119.02. Following the UST ‘burn,’ Luna prices fell to a fraction of a cent.

After Luna’s market cap dipped below that of UST’s, it became clear to investors that not everyone could ‘burn’ UST for equal value. The remaining holders of UST decided to cut their losses and sell their UST at lower and lower prices until it was worth a little more than a cent. At this point, it was obvious that the algorithmic stablecoin had collapsed beyond repair.

How did TerraUSD crash affect the industry?

Just as a pebble thrown into a calm lake will leave ripples that spread out until they eventually dissipate, the irreversible loss of UST’s peg to the US dollar and the crash in value of its sister token, Luna, sent shockwaves through the cryptocurrency market. But it’s possible the crypto lake was already subject to some waves of instability prior to the UST crash.

Bitcoin, for instance, had already spent several months fluctuating in value after falling from a historic high in November last year. This was most likely because the value of Bitcoin was closely aligned to the downturn of non-cryptocurrency assets, particularly tech stocks.

That said, UST’s implosion was undoubtedly a factor in Bitcoin’s subsequent sharp tumble in early May this year. For a few days in May, the collapse of UST may have accelerated the decline Bitcoin was already experiencing as an effect of the broader tech market downturn.

Some of this decline would no doubt have been related to a loss of confidence in crypto as investors were spooked by UST’s tumble, but part of it might have also been a result of the Luna Foundation Guard selling off billions of dollars’ worth of Bitcoin to repair UST’s peg.

There was a spike in stablecoin redemptions during UST’s collapse in the days following the initial tumble, with hundreds of billions more stablecoin than usual being sold for cash. This included the full spectrum of crypto buyers, from retail investors to big, institutional investors.

All kinds of stablecoins were redeemed for cash during this period, both algorithmic and asset-backed, suggesting that UST’s collapse freaked investors out across the board, not just those focused on a particular class of stablecoin. However, returning to the pebble analogy, the ripples caused by UST’s crash did eventually dissipate, with the accelerated decline in Bitcoin value ending around 13 May, coinciding with the endpoint of UST’s collapse.

After that point, Bitcoin’s value trajectory fell back in line with non-crypto tech assets, where it had previously been. Likewise, other major stablecoins weathered the storm whipped up by UST’s fall from grace, even if Tether (USDT), one of the more reliable stablecoins out there, did dip briefly to US$0.97. Like others, it returned to its peg and was able to process billions of dollars’ worth of redemptions of USDT over a week-long stretch following the UST action.

What’s next?

There has been no small amount of discussion about how to make stablecoins more stable following the fall of UST, with some commentators calling for more stablecoin regulation.

Whether or not such calls are answered by lawmakers remains to be seen. In the meantime, UST’s collapse may dampen investors’ confidence in the short term, but it’s unlikely to stop the progress of responsible innovation and forward momentum in the crypto industry.

Thanks to blockchain technology’s transparency, it’s possible to learn from incidents like UST’s collapse to educate ourselves and each other, and continue to build trust in cryptocurrency.

Cryptocurrency technology has the potential to solve many problems in many industries, not least the financial sector, and cryptocurrency does present a legitimately intriguing alternative to the everyday fiat currency. For one, it is largely immune from inflationary pressures, a force that plenty of people in multiple regions are battling with at this very moment.

Additionally, cryptocurrency’s decentralised nature means there’s no single point of failure that could prevent its use or operation. This decentralisation also makes it harder for monopolies to develop, because the organisation and management of the crypto is shared.

Perhaps most relevant to consumers, cryptocurrencies represent an incredibly cost-effective, reliable and efficient means of transaction. Not only can they be bought and sold with any number of national fiat currencies, they can also be used to send money across borders without the usual delays, fees and exchange rate issues that cash invites.

The fall of UST may have given many crypto investors reason to pause and reflect on the viability of stablecoin as a legitimate alternative to fiat currency or other assets, but the underlying issues leading to its crash have provided the crypto community with valuable lessons with which to build stronger and more reliable systems going forward.

Kim Grauer is the Director of Research at Chainalysis.