Why did UST lose its peg and what can we learn from this?

Please note: Yield App has never had any exposure to either UST or LUNA, as these assets never passed our rigorous risk assessment. This article is for informational purposes only.

• Terra’s native algorithmic stablecoin USD Terra ($UST) lost its peg to the US dollar this week
• The most important reason UST didn’t pass our due diligence was our concern about liquidity, as our DeFi team felt it would not withstand a large-scale sell-off
• In the long run, this story could have a positive impact on the maturing digital asset market, leading to regulation and better customer protections

Times of adverse market conditions and high volatility can be challenging for investors, not least because of the extreme uncertainty as to why things are unfolding as we are seeing this week. Amid already volatile market conditions, Terra’s native algorithmic stablecoin USD Terra ($UST) lost its peg to the US dollar, hitting a low of $0.26 on 11 May 2022, leading to a cascade of liquidations and a loss of confidence in Terra, previously the largest crypto ecosystem after Ethereum. 

Once again, we would like to reassure all our customers that we have never had any exposure to either UST or LUNA, as these assets never passed our rigorous risk assessment. Despite this, it is natural to be concerned about the implications for the wider digital asset market and one’s own holdings. After all, stablecoins are a key part of the Yield App offering. When fear and panic dominate the markets, it's important to know that your portfolio is safe.

So let's take a look at why UST has lost its parity with the US dollar, what we can learn from recent events, and why your assets are not at risk from the recent market turmoil.

How UST lost its US dollar peg

Stablecoins are digital representations of various fiat currencies. Their growth, fueled by their utility, has been parabolic as they establish themselves as the backbone of the emerging decentralized finance (DeFi) ecosystem. Unlike fiat-collateralized coins such as Circle USD (USDC), UST is an algorithmic and decentralized stablecoin, which is not backed by an equivalent of US dollar reserves. 

Terra uses open market arbitrage incentives to encourage users of the Terra ecosystem to hold UST at its peg. A “mint and burn” mechanism allows UST to be minted while burning the US dollar equivalent of its sister token, LUNA, and vice versa. 

This incentive mechanism works as follows (assuming a LUNA price of $100):

• Burning one LUNA mints 100 $UST, and vice versa, you can burn 100 $UST to mint one LUNA. 

• Should UST trade above its peg at $1.20, you could burn one Luna worth $100 to mint 100 UST worth $120, a 20% premium, and sell those on the open market. This arbitrage opportunity will increase the amount of UST in circulation and eventually bring UST to parity with the US dollar. 

• When UST is trading below its peg, let’s assume $0.50, 100 UST worth $50 would mint one LUNA worth $100, which in turn could be sold on the open market, reducing the $UST in circulation until it reaches its peg again. 

This highly scalable mechanism allowed UST to become the third-largest stable coin in circulation, just behind USDT and USDC, with its market capitalization increasing 50-fold in 2021. But this seemingly successful approach has also been criticized as unsustainable on concerns that UST was not insulated from market volatility. 

We have already witnessed this in 2021, when liquidation events across the market spilled over to Terra's ecosystem. On 23 May 2021, $UST briefly lost ground and fell to $0.92 due to large liquidations in Terra's Anchor Protocol, which holds the majority of Terra's TVL at around 62%. 

On 7 May 2022, a UST demand shock and already volatile market conditions led to extreme pressure on the mint and burn mechanism. As UST dropped slightly, burning UST to mint the US equivalent of LUNA became unattractive as the LUNA token was already in free-fall. Additionally, liquidations in the Anchor Protocol further accelerated this process. As users lost confidence in the ecosystem, both UST and LUNA were rapidly sold on the open market, causing both to fall further, eventually leading to a capitulation event.

Yield App’s position

With stable coins at the core of our strategy, many in the community had requested us to add UST to our stablecoin portfolio. However, there are several reasons why $UST did not pass our rigorous due diligence process. The most important reason was our concern about liquidity, as our DeFi team felt it would not withstand a large-scale sell-off. At the time of assessment, the ecosystem was unable to convert approximately 90% of circulating supply of UST for a 1:1 parity with US dollars, leaving the asset vulnerable to a bank-run scenario.

A key driver of demand for UST are highly leveraged yield strategies. By recursively looping their deposits through the Anchor Protocol, speculators have been able to achieve unsustainable returns of 20-130% APY on $UST. These bets are prone to liquidation cascades as once yields fall, UST will be sold on the open market, impacting the UST peg and causing liquidations of positions on Anchor, which is even further accelerated in volatile market conditions. 

These inherent systematic risks demonstrate why it is absolutely necessary to maintain a rigorous due diligence framework. After our DeFi team evaluated UST using our proprietary 135-point risk model, UST did not meet our capital deployment approval thresholds. As a result, we have never had any exposure to UST in our portfolios and it was never part of our yield-generating strategies. 

What can we learn?

The biggest collapse of a stablecoin so far, accompanied by immense losses of assets and trust of investors and users, will not remain without consequences. US Treasury Secretary, Janet Yellen has already reiterated her call for Congress to approve the regulation of stablecoins. However, in the long run, this story could have a positive impact on the maturing digital asset market. If regulators establish a sensible regulatory framework for stablecoins, this could finally propel these digital assets into the mainstream.

Stablecoins are an extremely important part of the digital asset market. They allow you to escape market volatility and are the backbone of the emerging DeFi ecosystem, but the recent story highlights that they are not risk-free. As such, it is absolutely essential that users do their due diligence and research before investing.

We believe our risk assessment capability is exactly the value we provide. We only list tokens that have gone through our stringent due diligence process, so our customers don’t have to conduct this research themselves. Our decision not to list UST is a good example of how Yield App always puts the security of our clients' assets first. 

Do you want to earn the market’s leading interest rates on your digital assets? Sign up for a Yield App account today!