What is UST and why is it causing crypto chaos?

Never a boring day in crypto.

On Monday, the prices of popular cryptocurrencies such as Bitcoin, Ethereum, and many others, went sharply down, following nearly two months of constant redness.

The decline was rapid, but that’s fairly usual in the world of crypto. What was unusual was the UST stablecoin, which is supposed to always be valued at one U.S. dollar, suddenly being priced at $0.6 before recovering to $0.9 at writing time.

If it were just some tiny little crypto project, no one would bat an eyelash, but UST, or TerraUSD, has a market capitalization of roughly $16.7 billion (well, it should be well over $18 billion, but again, the UST is currently valued below $1, hence the anomaly), and is one of the biggest stablecoin projects in crypto (a stablecoin is a special type of cryptocurrency that closely matches the price of a real-world asset).

Why is this bad?

Well, imagine the U.S. dollar losing value. Wait, that’s not that hard to imagine, it’s called inflation and it’s currently rampant. OK, but imagine the USD losing purchasing power in a matter of hours or minutes. The bagel that cost $3 this morning is $4 in the afternoon, and the amount of dollars in your bank account hasn’t grown to match this discrepancy. Something like that would cause chaos in the U.S. (and global) economy, with prices of transportation suddenly increasing (to name just one issue) and causing other prices to grow even more, ultimately making it hard or impossible for many people to purchase essential goods such as food.

In the world of cryptocurrencies, things aren’t that bad because entire countries’ economies aren’t at stake, but they’re still bad. Anyone who counted on UST being valued at $1, for example someone lending UST on a decentralized finance protocol, is in trouble. And in some ways, the UST dumping in price is also affecting the price of other cryptocurrencies, such as Bitcoin.

How could this happen?

The UST is a special type of stablecoin that’s called an algorithmic stablecoin. This means that, unlike USDC and USDT, it’s not backed by actual cash in a bank, but it maintains its peg to the dollar via some other mechanism.

The intricacies of how UST works are fairly complex; check out the excellent Twitter thread below to learn more, or read the official documentation.

Tweet may have been deleted

Here’s a simple version. The UST was created and is maintained by a company called Terraform Labs, which also maintains the Terra blockchain. It has a “sister” cryptocurrency called LUNA, to which it is inextricably linked, as you must burn (crypto lingo for destroying) LUNA to create UST and vice versa, and you can always (in theory) exchange 1 UST for $1 worth of LUNA. The system is designed to take advantage of supply and demand; should demand for UST drop and its price lose peg to the dollar, arbitrageurs (traders who make money from market inefficiencies) will (in theory) sell LUNA for UST until the balance is restored.

The mechanisms of supporting UST’s price are semi-automated and work well in most scenarios, even when there’s lots of volatility. But they do not work well in extreme scenarios, such as market demand for LUNA and/or UST disappearing overnight.

There’s another mechanism that protects UST’s peg to the dollar. Called LFG (Luna Foundation Guard), it’s a well-funded organization that can add collateral needed to protect the UST’s price. The easy way to do this would be to just deploy dollars, but the LFG has been buying massive amounts of Bitcoin, adding it to the treasury that can be used to protect the UST’s price.

Bitcoin’s price is itself volatile, and it’s not doing well in the current macroeconomic climate, with the Fed switching from quantitative easing to tightening, supply chain wreaking havoc in manufacturing, and the war in Ukraine raging and adding even more jitters to the already shaky markets. The result? Prices of stocks have been dropping rapidly in the last couple of days, with Bitcoin, itself also widely considered to be a risky asset, following. So now those Bitcoins that LFG recently bought are worth less, and the LFG may be forced to sell them for dollars at a lower price.

The LFG’s coffers are deep, and there may be other large investors willing to jump in and help maintain the UST’s price. But the trust in UST has been shaken, and some people fear it may go to zero, so they’re selling it just to get rid of it sooner rather than later.

It may not all be accidental

When you have a playground in which you can make actual money, with few limitations as to what you can do, and you introduce something like UST to it, there will be someone who will think to take advantage of it. Say, wait for the perfect outside circumstances, then dump massive amounts of UST in order to depeg it, and then, amidst the panic, short LUNA (shorting is betting on the price of an asset going down), and perhaps even buy massive amounts of UST before it restores peg. That’s just a simplified example, but someone has been selling a lot of UST and shorting a lot of LUNA.

What happens next?

These things happen. UST had a couple of crises like these before, and it always restored its peg to the dollar, and it might happen this time as well (the price of UST has been rising in the past couple of hours and, while still pretty far from $1, it seems to be getting there). Or UST could fold, hurting many investors in the process and bringing more uncertainty to the market. Should LFG be forced to sell all of its Bitcoin, that would probably be bad for Bitcoin’s price. Long-term, however, Bitcoin, Ethereum, and other stablecoins should be fine.

What are the lessons to be learned?

The obvious one is that cryptocurrencies are risky, but you probably knew that already.

Also, the crypto market is young, and decentralized app platforms like Ethereum are providing essentially infinite possibilities for creating various financial products. These products haven’t been tried and tested the way traditional finance has, and things can go wrong fast and hard.

More precisely, algorithmic stablecoins – while not inherently bad – are especially risky. A stablecoin that’s backed dollar for dollar, with dollars held in actual cash in a bank somewhere, is a lot less likely to lose peg against the dollar. An algorithmic stablecoin, though always partially backed by something valuable somewhere, is…well, complicated. And though things may seem fine 99 percent of the time, on that one odd occasion when the markets start crumbling, the mechanism protecting its value may fold. Stay safe out there.

Disclaimer: The author of this text holds small positions in LUNA and UST, acquired to gain a better understanding of how the system works.