The main reason algorithmic stable coin UST failed was that the foundation behind the Terra system project got “greedy” and allowed way more debt than they could sustain, making the Terra system vulnerable to an attack and panic sell. Let me explain how and why the Terra system collapsed.
UST (the “stable coin”) is supposed to be pegged to the US dollar in a ratio of 1:1. The peg is maintained by pairing UST with a sister cryptocurrency Luna, which is part of the same Terra system. Luna is a volatile cryptocurrency, the price of which depends on multiple factors, such as market conditions and investors’ confidence. You can create 1 UST by burning 1 dollar worth of Luna and burn 1 UST for 1 dollar worth of Luna.
When you link two coins together (Luna and UST) and force the price of the second coin, UST, to be equal to 1.00 USD with the help of the first coin, Luna, you double the volatility of the first coin, Luna. So to achieve this artificial stability in UST, the system sacrifices and increases the volatility of Luna.
If you are familiar with car mechanics, you can think of the system as a differential gear system, where you have two wheels paired to each other through the differential shaft. If one wheel is forced to be stuck while the shaft is in motion, the second wheel spins with double the speed.
Why did the Terra system fail?
Think of the Terra system as a bank ABC. When people deposit their currency in the bank, the bank ABC has to give that currency back to the holder whenever they want to withdraw it. Similarly, whenever 1 UST is created Terra system is on the hook to pay $1 back in Lunas to the UST holder whenever they decide to change it. So, when people deposit currency to the bank ABC, that currency becomes a debt obligation (liability) of the bank and its shareholders. In plain English, the bank owes you what you deposited. In a similar way, UST is a debt obligation of the Terra system and Luna holders.
Now, think of people who buy Luna coins as people who hold shares of the bank ABC. Whenever the bank ABC gets more people to deposit money, the bank expands, and the shareholders of the banks also get richer as the price per share goes up. However, when there is a “bank run” situation, and everyone who deposited their currency in this bank withdraws it, and the bank can’t give back everyone’s money, the bank declares bankruptcy, and all the shareholders of the bank suffer since their shares are now worthless.
Similarly, when more people were buying UST, the price of Luna increased because $1 worth of Luna was burnt, decreasing the supply of Luna. At the beginning of July 2021, the price of the Luna coin was around $7; since then, it steadily grew and reached over $100 at its peak in March 2022. The market capitalization of Luna increased, and this allowed to create even more UST with one Luna. However, when the “bank run” happened on May 9th, a massive amount of UST was sold at once. When someone burns 1 UST, they create $1 worth of Luna, which increases the supply of Luna. As people sell their Luna on the market to purchase other assets, the price of Luna coins decreases. When a massive amount of UST was burnt at once to Luna, the Luna coin was quickly devalued. This is exactly what happened. In two days, the price of Luna went from 80$ to around 0. Like the shareholders of a bankrupt bank, Luna holders lost everything.
The bank can only collapse during the “bank run” situation when they have more debts than assets. Similarly, the foundation behind the Terra system was greedy and took on more debt than it could sustain. Just before the “bank run”, the market capitalization of Terra system Luna was 29.6 billion, and its debt (which is a UST circulating supply) was 18.6 billion.
This means that the debt was more than 60% of the total market capitalization, which is way more than what is implemented on other algorithmic stable coins (a 20% threshold is used for HIVE and HBD stable coins). Under this model, in order for the Terra system to become bankrupt, the market cap of Luna had to drop just by 40%, which under current volatile market conditions was pretty much guaranteed. Basically, when the price of Luna drops below this value, the Terra system “shareholders” collectively owe more money than the combined value of their “shares”. When you buy a coin like Luna that is paired with an algorithmic stable coin, you are on the hook and risk the coin being devalued.
After the collapse as of May 16, 2022, Luna’s market capitalization is around 1.36 billion, but its debt is 11.3 billion dollars, so its market capitalization is only around 15% of its debt.
This means 11.3 billion UST has to be yet to be paid out. This is why it doesn’t make sense to buy Luna now for “cheap” in the hopes that it will recover soon because it still has 11.3 billion in debt to pay out if it ever will. So, unless Terra system’s foundation group comes up with extra 10 billion dollars, I don’t see Terra system recovering.
The tragedy here was that many people had confidence in UST and Luna since the Terra system seemed too big to fail. This event reminds us that we shouldn’t judge the assets by their market capitalization and invest just because everyone else is investing but look into their fundamentals, such as the structure, underlying assets, debts, and revenue. So, before you invest, you must always do your own research and understand how tokenomics works.
This article is for education only and is not financial advice.
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