In the craziest crypto week ever, the collapse of Terra's UST stablecoin turned out to be the biggest news. So what happened? How did UST lose its peg?
How did UST lose its peg?
Stablecoins are digital representations of various fiat currencies. Its growth, driven by its utility, has become parabolic as it establishes itself as the backbone of the burgeoning decentralized finance (DeFi) ecosystem.
Unlike fiat-backed coins like Circle USD (USDC), UST is an algorithmic decentralized stablecoin that is not backed by the equivalent of a US dollar reserve. Terra will use open market arbitrage incentives to encourage users of the Terra ecosystem to continue with UST. The "mint and burn" mechanism allows UST to mint while its sister token LUNA equivalent USD is being burned and vice versa.
This incentive mechanism works as follows (assuming a LUNA price of $100):
- Burning one LUNA mints 100 $UST, and vice versa, you can burn 100 $UST to mint one LUNA.
- If UST trades above the $1.20 peg, you can burn $100 Luna to mint $120 worth of 100 UST and sell it on the open market. This arbitrage opportunity will increase the amount of UST in circulation and eventually bring UST to parity with the US dollar .
- When UST trades below the peg, for example $0.50, 100 UST worth $50 can mint $100 worth of LUNA and sell it on the open market, increasing the reduction in UST until it hits the peg again.
- This highly scalable mechanism allowed UST to become the third-largest stablecoin in circulation, just behind USDT and USDC, with its market capitalization increasing 50-fold in 2021. But this seemingly successful approach has also been criticized as unsustainable on concerns that UST was not insulated from market volatility.
This was seen in 2021 when a market-wide liquidation event spilled over into the Terra ecosystem. On May 23, 2021, $UST fell briefly to $0.92 due to a major liquidation on Terra's anchor protocol, which owns the majority of about 62% of TVL in Terra. On May 7, 2022, the UST demand shock and already volatile market conditions put extreme pressure on mint and burn mechanisms. Since UST fell so easily that LUNA tokens were already in free fall, burning UST and minting the US equivalent of LUNA became unattractive.
Additionally, the liquidation of the Anchor Protocol furthers this process. Both UST and LUNA were quickly sold on the open market as users lost trust in the ecosystem, and both continued to fall, ultimately leading to a surrender event.
Now, I hope you get the answer to "How did UST lose its peg?"
