CryptoCompare Research - Exploring Stablecoins: Terra & UST's Fall From Grace

Terra LUNA and UST's fall from grace has been one of the most impactful events in crypto - comparable to the collapse of Mt. Gox in 2014 and the sharp market crashes that occurred in January 2018 and March 2020.

In the last three days: 

• UST’s peg has fallen to a low of $0.078. At the time of writing it is trading at $0.08.
• LUNA’s market capitalization has fallen from $41.2bn to $6.6mn, the largest destruction of wealth in this amount of time in a single project in crypto’s history.
• Over 6 trillion new LUNA tokens have been minted, which has diluted its price down to $0.00000953.
• LUNA supply is currently 16,928x what it was 48 hours ago.

Below, CryptoCompare details the events of the last few days, the repercussions, the aftermath, and what's next for the space. You can access the full report here.

TerraUSD's Fall From Grace

Terra's decline began on May 8th following a slight depeg of Terra’s flagship UST stablecoin to 0.9888. Although this seemed like a slight hiccup at the time, things quickly went from bad to worse, and on May 10th the stablecoin fell to a low of 0.755 (based on CryptoCompare’s CCCAGG pricing). On May 11th, UST reached a low of 0.2928. 

Terra's decline revolves around the mechanisms behind its algorithmic stablecoin, UST. Unlike Tether (USDT), this type of stablecoin is uncollateralized, primarily relying on arbitrage mechanisms to sustain the peg. In theory, if UST falls below the peg, arbitrageurs would be able to redeem this for $1 of LUNA and pocket a risk-free profit. Thus, LUNA’s supply (and therefore, price) can be dependent on this arbitrage mechanism and acts as a volatility absorber for Terra’s stablecoin.

Over the last few days, there has been severe sell-side pressure on UST across different crypto channels. This pressure meant the above arbitrage mechanism was not sufficient to maintain the peg.

A temporary depeg led to FUD in the Terra ecosystem (Fear, Uncertainty, and Doubt) which caused a loop between further selling of UST, which exacerbates the depegging of the stablecoin, and thereafter leads to more FUD and more selling – hence the reference of a ‘death spiral’.

Stablecoin Markets: How Fragile Are USDT And Others?

In wake of the UST incident, other algorithmic stablecoins have been subject to extreme sell-side pressure - FRAX saw a slight depeg on May 9th, and has been depegged for the majority of the past two days. Most recently, Tron launched its own algorithmic stablecoin - USDD - which has also experienced some depegging since its launch on the 2nd of May, exacerbated by the collapse of Terra. 

However, the most significant follow-up case has been the depeg of USDT, due to similar sell-side pressure across different crypto avenues. Contrary to TerraUSD, USDT is a collateralized stablecoin, and is thus fully backed by reserves including cash and cash equivalents like commercial paper. 

In theory, collateralized stablecoins like USDT should not suffer a similar crash as TerraUSD - given they are fully backed, they have sufficient reserves to redeem any USDT for fiat currency. However, Tether has depegged in multiple instances in the past, most notably in 2018 when it fell to $0.861 - it then took 3 weeks for the peg to be restored. Given USDT’s reserves, we do not believe there is a risk of a permanent depeg of the stablecoin, but rather, fear in the markets has had contagion effects on the entire sector. 

All in all, the stablecoin sector will see a drastic change over this period. While TerraUSD had threatened the status quo of collateralised stablecoins, these have and will grow stronger from this event. We see two clear winners from this crisis:

• First, USDC, a collateralised stablecoin which has had little controversy in the past, unlike its main rival USDT. It has a clear governance process and has been subject to monthly attestations by Grant Thornton LLP which assess the value held as reserves for the stablecoin. While USDT provides similar reports on a quarterly basis, its exposure to unknown commercial paper provides a source of concern for investors. 

• Second, DAI, a decentralized stablecoin which is fully collateralized by a range of digital assets. Its governance token MKR is used by holders to make decisions on the direction of the protocol. In this sense, DAI was a direct competitor to TerraUSD, both aiming to be the leading decentralized stablecoin, albeit via different stablecoin models.

The Aftermath Of Terra

The downfall of LUNA and UST has had repercussions on the wider crypto market. Unsurprisingly, Bitcoin and Ethereum are down -15.0% and -22.5% from May 8th to May 12th. Since the start of the year, the entire crypto ecosystem has lost $1tn of its market capitalization - an almost 50% decline. Apart from the FUD created by these recent events, individuals with leveraged positions in the LUNA ecosystem have been liquidated, leading to forced selling of other digital assets like Bitcoin and Ethereum. 

More importantly, there is significant exposure to UST in much of DeFi, as well as traditional finance products that provided depositors with high yields via Terra’s Anchor protocol. Many of these protocols and end-users will suffer the consequences of the bank run on Anchor and UST. The table below outlines some major protocols, applications and firms which had exposure:

What's Next? 

The debacle in TerraUSD has stunned the entire crypto community. It is worth noting that many investors saw the flaws of the algorithmic stablecoin system, with pseudonymous individuals betting millions with Do Kwon on the future price of LUNA. These investors, as well as those who have shorted LUNA, have seen significant profits.

Looking forward, the digital asset space is undoubtedly in a bear market. As aforementioned, we believe it will take time for the market volatility in the ecosystem to subside - in these coming weeks we will find out the true cost of this crash. Many projects that were launched during the bull market of the last two years will struggle to survive, specifically those that provide no long-term value, and that may not have access to further capital. Thus, it is very possible, even probable, that crypto markets have some more downside to go, particularly amidst a restrictive macroeconomic environment. 

Having said this, the digital asset space has forever experienced these volatile events. The drawdowns we are currently seeing in Bitcoin and Ethereum, over 50% down from all-time highs, have been experienced on many previous occasions - the COVID-19 crash, the bubble burst of 2018, and the bankruptcy of Mt. Gox in 2014 are some important examples. Cryptocurrencies remained following all of these events, and we believe this will be no different. 

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The information provided by this report does not constitute any form of advice or recommendation by CryptoCompare. Any redistribution of charts appearing in this Review must cite CryptoCompare as the sole provider and creator.