Terra’s UST Dip Raises Questions on Algo Stablecoins

Crypto markets went haywire last week and while extreme volatility is expected from most tokens, stablecoins are the one category designed to peacefully weather the storm. The stablecoin issued by the Terra network, UST, got mixed marks as it dipped well below its peg.

UST dropped to as low as $0.89 on May 19, or 12% from $1, and hovered between $0.99 and $096 from May 20 to May 24, before climbing back to $1 today. The drop was the biggest in CoinGecko data going back to October 2020. Comparatively, the USDC stablecoin fluctuated between $0.99 and $1 in that time, with only one drop lower to $0.98 on Jan 4. 

Terra’s UST volatility raises questions about the viability of so-called algorithmic stable assets –– or pegged tokens that are designed to keep their stability via protocol incentives and mechanisms, rather than by having collateral backing them. While the most liquid stablecoins, USDT and USDC, are backed by US dollars held in banks, algorithmic coins have emerged in the past year with the promise of offering stability without having to rely on third parties or fiat currencies.

UST’s drop was in part driven by a sell-off in Terra’s native cryptocurrency LUNA, which plunged by as much as 80% to $4.18, the lowest since Feb 27. That’s because UST relies on LUNA for its stability: The Terra protocol acts as a market maker, making sure that when the supply of UST goes up, the LUNA supply goes down, and vice versa. 

Users can swap $1 worth of LUNA for 1 UST, and vice versa. The system is designed to handle $20 million of redemptions with a 2% spread. But the sharp price declines in LUNA, compounded by large amounts of liquidations on Terra’s lending protocol Anchor, drove redemptions from LUNA to UST to exceed $80 million, forcing UST to trade at a discount.

“Endogenous Collateral”

Relying on Terra’s token LUNA to maintain the stability of its stablecoin is risky and could create a “bank run effect,” Ariah Klages-Mundt, developer of the Gryroscope stablecoin, said on Twitter.

“We are now in a dangerous spiral: as users panic out of UST, this reinforces the Luna crash further,” Klages-Mundt tweeted on May 23.

In plain terms, Klages-Mundt meant that if the UST is backed by an “endogenous collateral” like LUNA, or an asset that exists within the same financial ecosystem as UST, concerns about Luna prices could lead to a cascading sell-off where more and more people withdraw their UST funds over concerns about Terra’s solvency. This, in turn, increases the probability of Terra defaulting, which leads even more people to withdraw their funds, thereby reinforcing the LUNA crash.

Market Volatility

Terra co-founder Do Kwon responded to Klages-Mundt’s concerns, saying that while the Terra system allows for swaps between the two assets to achieve stability, UST is not explicitly backed by LUNA. As long as LUNA has a non-zero market value, the Terra system can offer incentives to bring UST price back to peg, especially considering the stablecoin is actively being used in its CHAI payments network with over 78,000 daily active users. 

Do Kwon further noted that it doesn’t matter if LUNA’s market cap is lower than UST’s market cap, as Klages-Mundt pointed out, as it can incentivize the arbitrage between the two coins as long as its price is greater than $0.  He said the system has been working as intended with UST trading at exactly the swap spread parameterized into the protocol.

Klages-Mundt said  that it didn’t matter whether or not Luna market cap was explicitly collateral, as it is still effectively backing UST. 

The Defiant has reached out to both  Klages-Mundt and Do Kwon for comment, and will update the article accordingly. 

Looking forward, it remains to be seen whether or not the UST can hold its peg long-term amidst massive market instability. But for those who value total decentralization above fiat-backed stablecoins, the UST has recovered nicely even after LUNA’s drop.