Market Byte: What’s Happening to UST?

This weekend, the third largest stablecoin, Terra USD (UST), lost its peg1 to the dollar, sending the price of LUNA into a downward spiral. Attempts to recover the peg resulted in additional sell pressure on Bitcoin and Ethereum while the market was already in a downward trend going into the weekend. UST, the native stablecoin of the Terra smart contract platform, had a market cap of $18b before losing 20% of its market value — over $4b — nearly overnight before recovering back to $16b on May 10th. So what happened? Why did so much value vanish and what does this mean for the future of stablecoins? First, let’s talk about the Terra ecosystem where UST originates. Terra is a smart contract platform with the native token LUNA and stablecoin UST. UST is an algorithmic stablecoin, meaning the stability mechanism of UST <> LUNA should always allow for $1 of UST to be redeemed for $1 of LUNA. Therefore, if UST loses its peg from $1 to $0.50, someone could buy 100 UST for $50 and redeem it for $100 of LUNA — making money on the arbitrage. However, if the price of LUNA is dropping with the peg, it becomes a race to redeem for LUNA before the value drops below the redemption price. Other decentralized stablecoins are most often backed through overcollateralization. For example, MakerDAO requires 150% collateral to mint DAI. Thus MakerDAO is better protected from the value of its crypto collateral dropping sharply overnight by having more collateral than circulating DAI. Meanwhile, UST is under-collateralized and the peg is entirely driven by on-chain incentives (the arbitrage mechanism), leaving it vulnerable to large market movements. The UST peg failed for two main reasons:
  1. On-chain selling – Curve pool imbalance
    1. $350m UST was swapped for USDT using the Curve protocol. This left a disproportionate amount of UST versus other stablecoins in the pool for users to swap against, lowering the value of UST on-chain
    2. Curve is a crucial piece of the DeFi ecosystem, allowing users and dApps to efficiently swap stablecoins. The massive selling of UST on Curve created an imbalance in reserves, leading to the value of UST falling below the peg on the protocol.
  2. Off-chain selling
    1. The remaining portion of UST withdrawn from Anchor protocol was sold on centralized exchanges like Binance driving down the value on those markets as well
Bank Run After months of collecting 20% APY in UST rewards from Anchor, users began to withdraw their tokens and cash out on May 7th. This exodus resulted in Anchor’s Total Value Locked (TVL) decreasing from $18b to $6b in just three days as users rushed to trade out of their UST positions. Approximately 70% of the UST supply was locked in Anchor, leaving the circulating supply of UST vulnerable to dilution if it suddenly floods the market — and that’s exactly what happened.
Source: Defillama

LUNA’s price decreased by nearly 60% as UST was redeemed for Luna and sold for dollars – as traders profited off the arbitrage mechanism.


Trading firms like Jump Crypto initially tried to restore the peg and rebalance the Curve pools by swapping ~$270M USDT for UST, but could not keep up with UST outflows from the pools. Separately, an unidentified wallet was also swapping increments of 1000 ETH to rebalance the UST pools every few minutes in an attempt to further defend the peg, totaling more than 30k ETH sold at the time of writing.


On Sunday, May 8th, the Luna Foundation Guard deployed its $1.5b in Bitcoin reserves and UST to maintain the peg. Trading firms have been tasked with deploying $750m in BTC to defend the peg and $750m in UST with the goal to repurchase the sold Bitcoin once stability returns.


Both of these attempts proved unsuccessful and the UST peg continued to drop, reaching a low of 61 cents around 8 pm EST on May 10th due to the scale of the run. At the time of writing, the peg is back up to 81 cents as the arbitrage mechanism continues to operate in the background.


Attempts to restore the peg by selling Bitcoin and Ethereum exposed a crucial point of weakness in under-collateralized stablecoin models. If the price of the collateral backing the stablecoin supply suddenly tanks, the peg becomes increasingly harder to defend as you’re forced to sell declining assets.


What Does the Future Hold for Algorithmic Stablecoins?

This incident raises questions about the future of stablecoins on-chain, however, the design of UST as an under-collateralized and demand-driven stablecoin is nothing other than an emulation of the US Dollar. 


While there may be challenges with projects like UST on Terra (LUNA) network or USDN on NEAR network, the push to continue innovating on-chain protocols and services remains important to the development of the broader crypto ecosystem. 


Fiat-backed stablecoins, like USDC, have taken the path of least resistance to bring US dollars on-chain. Collateralizing the token 1:1 with dollars or treasury bonds means that the market simply needs to agree that the collateral is there, rather than speculate on the changing value of the underlying collateral. 


Regardless of whether the price of Bitcoin falls further or skyrockets , builders will continue to innovate on the next iteration of stablecoins, taking into account lessons learned. For now, MakerDAO remains the premier decentralized stablecoin with over-collateralized crypto reserves backing the DAI stablecoin. The race to develop the first under-collateralized stablecoins remains to be won as projects like USDN on the Near Protocol or Frax Share on Ethereum gain popularity.


While UST has yet to return to peg, members of the Terra ecosystem are working hard to return the asset to $1 and reclaim some of the value lost this weekend. UST provided much of the on-chain liquidity on DeFi protocols, so we may begin to see second and third order effects if it fails to stabilize. However, as Barry Silbert pointed out on Twitter, most stablecoins that have lost their peg, eventually find themselves back at $1. We’ll see if this is the case with UST.

1 Peg – A dollar peg is when an asset intends to maintain a fixed 1:1 exchange rate to the U.S. Dollar.

Recent articles

May 2023 Monthly Recap

Posted on June 2, 2023

Market Byte: Counting Down to 2024 - Exploring Bitcoin Halvings

Posted on May 24, 2023

Business Organizations: What is a DAO Legally, Anyways?

Posted on May 17, 2023

Sign up and join the Grayscale community

* Required fields
Geometric shape

All set! Thank you.