Collapse of Crypto’s TerraUSD: causes and takeaways

May 19, 20224 min read
Collapse of Crypto’s TerraUSD: causes and takeaways
Share on facebookShare on TwitterShare on Linkedin

Key takeaways

  • TerraUSD (UST) is a popular stablecoin that’s linked through an algorithm to Luna, a sister coin that ensures the UST is anchored at $1.
  • When UST depegged from $1 on May 9, it set off a chain of events similar to a bank run, that eventually led to both UST and Luna’s catastrophic collapse.

  • Several triggers for the meltdown have been identified, including technical failures and the currency’s flawed exchange system.

The cryptocurrency market was hit with a wave of panic last week, as one of the most popular stablecoins, TerraUSD (UST) suffered a spectacular collapse, its market value plummeting to $1.3 billion from $19 billion earlier this year. Experts are split on the cause — some are pointing to the underpinnings of the currency’s sophisticated, yet ultimately flawed exchange system as the reason for its death spiral, while others are highlighting the technical failures that accelerated its demise. 

The Two sides of a Coin: TerraUSD and Luna explained

Ironically, TerraUSD was created as a type of stablecoin, so called because it’s pegged to a currency, commodity, or another financial instrument, unlike other cryptocurrencies like Bitcoin, that aren’t backed by collateral. TerraUSD is an algorithmic stablecoin, where its value is linked through an algorithm to the value of Luna (LUNA), a native coin found on the blockchain, Terra. Before the collapse, UST was one of the three largest stablecoins, with a market cap surpassing $18 billion. 

Luna is essentially a shock absorber for the volatility of TerraUSD through a burn and mint mechanism. Luna coins are burned (permanently destroyed) to mint (create) TerraUSD coins and vice versa, as a way to ensure that the value of TerraUSD stays anchored to $1. In theory, this means that users could swap the two coins at a guaranteed price of $1, regardless of the market price of either token at the time. A rise in demand for TerraUSD for example, is a risk-free profit for Luna token holders who could exchange their Luna tokens for the higher valued UST. 

The Death Spiral 

TerraUSD already faced criticism in its early days, because nearly 70% of its circulating supply was deposited in the Terra-based borrowing and lending protocol, Anchor, which offered 20% yield rates. Critics immediately doubted this set up, saying such a high return was unsustainable. 

The apprehension proved to be right. On the weekend of May 7, there was an outflow of roughly $3 billion of UST from Anchor, with large sums linked to just five addresses. Much of this withdrawal ended up on another blockchain, Ethereum and its exchange platform, Curve, where through a process known as bridging, TerraUSD could be swapped for other stablecoins.

Diversify Your Portfolio Today

On May 9, UST depegged from $1 and set off a chain of events, in a manner similar to a bank run. The withdrawal from Anchor, the swap on Curve and the general bearish market collectively led to heightened panic about the UST value, which created a negative feedback loop that incited further withdrawals from Anchor. The TerraUSD dipped to a low of 13 cents last week, while Luna tumbled to nearly zero.  

The trigger for the collapse, or the death spiral, is debated. Some blockchain experts blamed wealthy investors that may have led a “concerted attack” to short the currency, which then led to its collapse. Meanwhile, a report by Galaxy Digital Research pointed out that safety parameters set up to protect the burn and mint mechanism, such as a daily minting limit, could have undermined a more rapid reaction to initial depegging. Others went further back and argued that the fundamental design of the currency was flawed, since it’s essentially backed by faith in Luna, another cryptocurrency.

Damage was for the most part, irreversible. Even after Luna Foundation Guard, the nongovernmental organization set up to protect TerraUSD peg, dumped $3 billion in bitcoin to attempt a recovery, trading levels for UST hit an all-time low at 9 cents this week, while Luna hovered around zero.

One for the Books

The collapse of TerraUSD even caught the attention of the U.S. Treasury Secretary Janet Yellen, who urged Congress to pass stablecoin legislation last week, echoing a sentiment that’s been building momentum over the years. 

Meanwhile, market sentiment following the crash was mixed. Some pointed out that the relatively small market cap of TerraUSD isn’t enough to permanently damage the wider cryptocurrency market (market cap ~ $1.24 trillion) even though it was a historic loss. Bank of America found the contagion risk unfounded, since UST isn’t backed by traditional markets and remarked that the cryptocurrency market is, by nature, susceptible to similar headwinds. The steep decline surely left many investors spooked, but industry leaders also took to Twitter to express that such volatility was in line with what’s expected for cryptocurrencies, even stablecoins.

It is important to note that UST was an attempt at creating an algorithmic stable coin, which can be more cost effective than collateralized stablecoins (e.g., DAI, USDC). Thus, it is considered to be the holy grail among industry leaders, and venture capital funds and entrepreneurs will continue to chase that dream.

Yieldstreet’s Crypto Exposure

While the collapse of Terra/Luna impacted the whole crypto market, Yieldstreet’s enhanced Crypto Fund was not exposed to these two stablecoins, which underscores one of the benefits of investing in crypto through institutional investors rather than doing it yourself. In addition, Pantera capital – Yieldstreet’s other crypto opportunity – appears not to have suffered from the crash as it allegedly liquidated its position in Terra before the crash.