Statement on UST and LUNA by 21Shares

UST, the Terra protocol’s non-collateralized and algorithmic stablecoin, lost its peg and fell to roughly $0.30. As of writing, Terra’s native token, LUNA, fell by more than 92% over the last 24 hours.

In light of the depeg, Terra’s founder, Do Kwon, shared the recovery plan 72 hours after. The program will let LUNA absorb the UST supply from the holders who want to exit. For the project's future, the founder has mentioned that the team will stay and rebuild UST, potentially adjusting the mechanism to be a collateralized model.

What happened?

• On May 7th, 2022, UST began to lose its peg to the US Dollar. However, after substantial drawdowns to as low as $0.85, the stablecoin started to climb back towards the target $1 value after assurances by the Terra founder Do Kwon and backers such as Jump Capital and Alameda Research.
• On May 9th, a second depegging event stalled the recovery, and the token began a significant downward correction towards 20 cents on the dollar.
• The Luna Foundation Guard (LFG) announced multiple measures deploying a total of $1.5B worth of Bitcoin out of the treasury reserve to be used by market makers as a loan to act directly in venues to restore the peg.
• The initial plan was to provide the bitcoin reserve on Astroport, a decentralized exchange (DEX) so that users could have an option to redeem bitcoin instead of LUNA. However, the development is still a few weeks away from a testnet launch.
• As of writing, the stablecoin is trading below $0.50. Some of the largest market makers in the crypto industry are attempting to restore the peg of UST.
• Fully-collateralised stablecoins have depegged and recovered in the past. Still, given that the Terra ecosystem has been growing at such a high rate — reaching $30B in TVL and $40B in market value at its peak, this is the biggest event of its kind.
• Other stablecoins, mainly non-collateralised, which lost their peg, never recovered, including Empty Set Dollar, Dynamic Set Dollar, and Basis Cash. Some have become the market leaders, namely Circle’s USDC.

LUNA’s relationship to UST

• UST is a non-collateralized and algorithmic stablecoin which means that its peg is not maintained by virtue of collateral, but by the market action of arbitrageurs using a mint and burn mechanism akin to the creation and redemption mechanism of ETFs share.
• Terra provides an interface via which UST can always be exchanged for LUNA as if it were worth $1, whatever the traded value. If UST drops below $1 in value to $0.5, arbitrageurs can purchase UST at $0.50 and use it to mint LUNA as if it were worth $1.
• They can then sell the LUNA to capture the $0.50 profit per UST. This opportunity adds buy pressure to UST, bringing the price back up until the arbitrage opportunity disappears at peg. This is the mechanism Terra uses to peg UST to $1.
• But this also adds selling pressure to LUNA, bringing down its value. Under normal market conditions, the sell pressure from these arbitrageurs is not enough to affect the market price significantly. Still, in the extended de-pegging scenario and bear market we are in now, the value of LUNA dropped catastrophically.
• This is the fundamental cause for the price of LUNA to crash.

What is happening right now?

• The founder of Terra Do Kwon has officially announced on Twitter that the team has decided to let the arbitrageurs continue to exit the system until they all exit.
• The project will increase the minting capacity of LUNA in order to absorb the exit liquidity
• Once the collapse is complete, the repegging mechanism should reduce spreads over time and return UST to the $1 peg
• UST will also adjust from an uncollateralized mint-burn model to be a collateralised model
• This however does not have clear implications for the value of LUNA. This will depend on the narrative that develops after a potential recovery.

Regulatory Implications

• This event may have raised some flags to point knives at the underlying architecture of algorithmic stablecoins, being uncollateralized, as there is yet to be a legal framework regulating them.
• Even existing frameworks have yet to ensure that reserve-asset private stablecoins maintain adequate reserves.
• The pending Stablecoin Trust Act does not affect non-payment stablecoins (e.g., stablecoins backed by commodities or virtual currencies, or algorithmic stablecoins).