The collapse of TerraUSD (UST), which was once the third largest stablecoin, triggered a “death spiral” in the beginning of May. Within 3 days, the value of Luna dropped from around $90 to almost $0.
Key takeaways:
- The collapse of TerraUSD (UST) has led to suspicion of all stablecoins, highlighting that some rely on unstable reserves.
- Investors, politicians and regulatory authorities have expressed their concerns about stablecoins.
- Many believe that stablecoins are riddled with uncertainty and opacity, making them a threat to the global crypto industry and investors at large.
After a lackluster start to the year, the last couple of weeks at the end of March has brought a welcome change of ambience as far as price is concerned. Bitcoin markets have not seen seven consecutive days in the green since July last year, and many are wondering what could be happening in the background.
However, there was a recent unseasonably consistent rise in the crypto market from 2022 March to April. Moreover, we are tempted to conclude that the BTC reserve accumulation for Luna UST by its foundation has been a significant positive catalyst for this BTC price movement.
Terra is a cross-chain protocol built specifically to support a sprawling ecosystem of stablecoins and auxiliary apps and services. The protocol is meant to support its UST stablecoins pegged to any state currency. The UST stablecoin is algorithmically pegged to its state currency counterpart via an automated market making system (as such as Uniswap or Curve) setting swap rates between liquidity pools.
The market-driven arbitrage mechanism for maintaining UST stablecoins at their peg is highly vulnerable to the exchange rate of the Luna token against the state currencies on the other end of the stablecoin peg. Essentially, if Luna enters a protracted bear market against the USD, a ‘death spiral’ of sorts can arise.
This ‘death spiral’ is a vicious cycle whereby holders of stablecoins like UST — all of which are basically backed by the value of the Luna token through the burn-issue-swap mechanism — worrying that the backing of their stablecoin is at risk of collapsing, rush to redeem their stablecoins for Luna, looking to sell the Luna token for a stabler stablecoin, or even more stable digital assets like BTC or ETH on exchanges.
In the process, if the number of Luna tokens on the market increases rapidly, this will further fuel its negative price movement, and the vicious cycle is ignited. To avoid this outcome, Terraform Labs had teamed up with a set of VC backers to create a monetary reserve fund that purchased $1.4Bn bitcoin starting in January of 2022, as a backstop to any Luna ‘death spiral’.
However, the early-May collapse of TerraUSD (UST) has heightened distrust toward all stablecoins, algorithmic or not, and raised new doubts about what reserves, if any, are actually backing these stablecoins. Investors and users, as well as politicians and regulatory authorities, have expressed their concerns. Many people believe that stablecoins exist with uncertainty and opacity, which is dangerous to both Crypto investors and its economy as a whole.