How Terra Works (UST, Luna) – And Why It May be Doomed

With a $18b algorithmic stablecoin named UST imploding, I thought I’d explain how Terra/Luna/UST works for those unfamiliar.

Terra is a blockchain built on Cosmos SDK powering a suite of algorithmic stablecoins. The largest of these stablecoins is TerraUSD, or more commonly known as UST, which attempts to track the U.S dollar.

The Luna token is the governance token of the Terra ecosystem, and is used to stabilize UST and the other stablecoins.

How is UST created?

$1 worth of Luna can be exchanged for 1 UST. A portion of this Luna is burned (ie. removed from circulation), while the rest is deposited into the community treasury.

Conversely, 1 UST can be burned for $1 worth of Luna.

Basically, UST and Lunar are redeemable dollar-for-dollar. If Luna = $50, then one can redeem 1 Luna for 50 UST, or 50 UST for 1 Luna.

How does UST maintain it’s U.S dollar peg?

The UST peg is maintained through the Luna token, which acts as the shock absorber for peg volatility.

1 UST is guaranteed to be redeemable for $1 worth of Luna by the system.

  • If 1 UST < $1, then arbitrageurs can burn 1 UST for $1 worth of Luna, and then immediately sell that Luna for a profit. Demand for UST for this arbitrage coupled with decreasing UST supply should theoretically drive up UST price, while the increasing Luna supply decreases Luna price.
  • If 1 UST > $1, then arbitrageurs can burn $1 of Luna for 1 UST, and then immediately sell that UST for a profit. The increase in UST supply should drive down UST price, while decreasing Luna supply increases Luna price.

Let’s use some concrete examples:

Imagine that 1 UST = $0.80. Then someone could buy 1 UST for $0.80, exchange that for $1 worth of Luna, and then immediately sell that Luna, pocketing a 20c profit. 1 UST is burned, which in theory should have an appreciating effect on the UST price though that effect might not be immediate. Luna price would decrease.

Death Spiral

The problem is that if UST is devalued, it’s ability to maintain its peg is dependent on Luna retaining its value. But the arbitrage mechanism for increasing UST value inherently devalues Luna by increasing Luna supply. So when UST loses its peg, the more that arbitrageurs try to burn UST to restore the peg, the more Luna gets devalued as well. This could lead to a nasty death spiral.

Terra knows this, and so they’ve started diversifying their reserves by buying $3b of bitcoin ($10b total planned) through the Luna Foundation Guard, as well as some other tokens like Avalanche, Luna, and UST.

As I write this on 5/10/22, their reserves have tanked from $3b to $1b in a day, while UST is currently at $0.792 (-20%) and Luna at $34 (-44%). UST supply is 18.7b

Anchor Earn mass withdrawals

75% of UST supply has been deposited in Anchor Earn, a lending and borrowing protocol returning a staggering 20% return on UST deposits, though that yield had been decreasing as yield reserves run out. Clearly Anchor Earn’s enormous yield has been driving most UST demand.

As I write this on 5/10/22, Anchor has lost half of its deposits ($7b) in a single day. Depositors are fleeing amidst this massive UST depegging.

What’s next?

Although UST has faced a de-pegging before a year ago on May 17th, 2021 to $0.916, it hasn’t de-pegged even remotely as low as it has today.

Every other algorithmic stablecoin until this point has failed – ESD, DSD, Iron Finance, Fei, etc. Will Terra survive?

Personally I’d be shocked if Terra doesn’t fail. It seems to be crashing right now in real-time while reserves are depleting. As mentioned above, the arbitrage mechanism designed to correct UST devaluation devalues Luna by increasing Luna supply. Luna’s market cap of $12b is now less than UST’s market cap of $14b.

UST/Luna pegging is rate-limited in order to prevent price manipulation, which would explain why the peg is not being restored. If the markets turn around and things turn optimistic, there’s a possibility things could be restored. Also it’s possible that someone with massively deep pockets could jump in to the rescue. But I definitely would not bet any money on that.

Unless UST can actually get significant mainstream adoption driving UST demand outside just Anchor yield farming, and thus people treating UST like a currency, it’s hard for me to imagine Terra not failing. I certainly want Terra to succeed, but getting mainstream real-world adoption is very difficult. If Terra co-founder Do Kwon manages to save Terra here while the general markets continue to implode, that’d be quite the miracle.

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