Unstable Coins: What happened to LUNA and UST?
The headline rate of 19.5% APR on a US dollar stablecoin said it all. Until last week, the draw of such a return on your dollars was so enticing that corporates, investors and crypto newbies, were happy to throw significant sums of money into the algorithmic stablecoin UST.
LUNA Stablecoin
Created by the now-infamous Do Kwon and his company Terraform Labs, UST was a stablecoin on the Terra blockchain. Powered by its LUNA cryptocurrency they were building a DeFi ecosystem targeting mass adoption.
The darling of their ecosystem was the algorithmic stablecoin UST, which was launched only 18 months ago. However, off the back of its eye-watering yields thanks to the Anchor protocol on Terra, it propelled Terra from being just another blockchain to being a top 10 blockchain by market cap.
Prior to its collapse, UST became the third-largest stable coin hitting $18.3 billion in market cap, trailing only Tether (USDT) and Circle's USDC. Alongside this, the LUNA cryptocurrency powering Terra went from less than a dollar to over $100 at its peak in a little over a year.
Then it all came crashing down in the second week of May 2022. LUNA ended up being worth fractions of a cent, completely wiping out any holders of the cryptocurrency, and UST lost its dollar peg, ending up worth just over 10 cents on the dollar.
What really led to the fall of LUNA and UST?
There have been many write-ups on what caused the failure of UST and LUNA, but the speed at which everything happened and that LUNA itself went to fractions of what it had been worth are what many investors and everyday folk around the world are reeling from.
Algorithmic stablecoins are still a highly experimental concept in Web3. Unlike USDC and DAI, UST was not a fully collateralised stable coin. Instead, it relied on minting and burning LUNA tokens to maintain its price. Recently, bitcoin reserves had started to be built up as LUNA itself was a very volatile cryptocurrency to maintain UST’s price with. But the reserves were not large enough to fully back UST and enable it to live up to its premise.
In effect, LUNA and UST could be considered a true manifestation of magic internet money as they really were created out of thin air by the Terralabs project team. This meant that it was perfectly feasible to offer yields of 19.5% APR via DeFi protocol Anchor, as it wasn't like dollar reserves needed to be increased accordingly as with other stablecoins. Terralabs had the authority to be able to make such yields possible.
We've seen the same behaviour play out with other DeFi protocols, except in most projects there isn't a stable coin involved. When a project team creates a DeFi protocol, they create tokens out of thin air to incentivise their users. Staking services can then be created that generate fantastic yields for that token. As a result of the yield, folk start aping (rushing) into that project buying up tokens to generate yield and the price of the token appreciates.
The yields then come down as the token becomes more popular, but those early adopters often have made a very attractive return by getting in early. This behaviour by projects is no different to marketing incentives offered by traditional businesses, except that there is a token involved instead of a discount, gift or some other marketing incentive. If collusion is involved one can argue that these tactics are the same as those used by multi-level marketers and Ponzi schemes.
UST central bank?
The ability for Terralabs to be their own central bank for UST, is not too far removed from what has gone before in Web3. However, unlike prior projects before them, the fallout is likely to be somewhat different over the coming weeks and months. The reason being that UST wasn't simply a token, it was a stablecoin. It was positioned as a low-risk product in the incredibly volatile crypto markets as, unlike cryptocurrencies, it was meant to track the price of the U.S dollar.
It was also offered as a yield product by several centralized exchanges and neobanks. As a result of this, it wasn't just the usual DeFi degens jumping into UST, but also investors and the most naive users of all — the crypto newbies.
For these newbies using their neobank or centralized exchange, in their crypto dashboard, they would be presented with this UST product which looks and sounds just like US dollars offering a 19.5% return. Yes, there were all the usual disclaimers and fine print associated with it that you have with any investment. But for the average person, this on the surface is a far safer place to put your money than the volatile landscape of cryptocurrencies.
The savvy crypto market participants who have been in the space for a number of years know that these sorts of failures are part of the risk you embrace by investing in the space. But for those, newer, less experienced users who only got exposure to UST due to its widespread availability outside of DeFi are those who really got burnt.
As a result of this, the demise of UST is likely to be a pivotal moment for the crypto landscape. When everyday folk are affected by financial collapses, the regulators really take note. After all, they are the people regulators have to protect most of all.
How much money was lost by these everyday folk will no doubt come out in the wash as regulators start taking action against those platforms that didn't adequately articulate the risk to their users about investing in stablecoins. Stablecoins have been on the radar of regulators for a while now. While one should bundle experimental, algorithmic stablecoins like UST into a different bucket versus fully collateralised stablecoins like USDC, it remains to be seen what the regulatory approach will be like for classifying them.
The party isn't over yet, you can still obtain yields in the 4-7% range for stablecoins, however, as with all these financial returns. If you can't appreciate how these yields are being generated, it's important not to get suckered in regardless of how appealing it may appear on the surface.
It's never easy swimming against the tide, especially in the ever-changing Web3 landscape, but if you play the long game, focusing on the projects and protocols that have stood the test of time, and avoid letting FOMO push you to the latest project or protocol, you'll be in a better position to benefit from Web3 as the future continues to be built.
There is no doubt that we haven’t seen the end of algorithmic stablecoins. Perhaps, in the future, they won’t be allowed to have the word stable in them, which would likely prevent a lot of people from throwing money into them and history repeating itself.
Have any questions or comments? We’d love to hear from you! If you want to find out more about blockchain, its growth, and newest developments, then check our blog or listen to our enlightening Web3 Innovators podcast.
