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TerraUSD: The events that led to the crash of a stablecoin with over 20 billion marketcap

Terra USD (UST), recently rebranded to TerraClassicUSD (USTC), an algorithmic stable coin that is supposed to be pegged 1:1 with the US Dollar, seems to be the victim of an attack similar to how the bank of England had fallen victim in 1992 in a move by George Soros. With a price of only $0.42 per token, it is currently in a tough battle facing a significant risk of permanently losing all its value. How did UST lose over $50 billion, and what does it mean for the crypto ecosystem? Let's dig in to find out!

TerraClassicUSD on CMC

By Rick van Melis Explainers

4 min read

TerraUSD: The events that led to the crash of a stablecoin with over 20 billion marketcap

Introduction

Before we begin, let's try to understand the workings of UST. UST is an algorithmic stable coin, rather than having a reserve basket of fiat like the US Dollar and euro functioning as collateral to maintain the peg (similar to USDC, USDT, and in part our banks) they use a secondary token called LUNA as a stabilizer. Luna has a free-floating value and grows as the terra ecosystem is used and speculators buy the token. Whenever the price of UST falls below a dollar (1:1), new LUNA is minted and sold at a discount to buy and burn UST from the open market, increasing the value of UST in the process. Vice versa, when the price of UST is above a dollar, traders are incentivized to burn Luna in exchange for a dollar in UST, increasing the supply and theoretically resulting in the price eventually dropping back to 1$. It is assumed that through these incentivizations, traders will arbitrage on the price differences, and stabilize the market. As we can see things can start to differ when there are bigger market movements because there is not a lot of real collateral.

Deep Dive

So what has happened now? For a long time, critics have been saying that one of Terra's most significant utilities, Anchor Protocol, similar to a savings account, might not have sustainable interest rates [1] [2]. Hence there could have already been some fear building up amongst its users. From then on, as stated by several Twitter sources the story starts around March when the Luna Foundation Guard (LFG) started buying Bitcoin (BTC) to act as collateral in times of need. By March 26th, 2022, they had accumulated over $1bn+ worth of Bitcoin, this is the first leg that made the attack possible.

LFG Reserve now backstops UST Peg

The second leg comes in the form of an announcement for the 4pool, a soon-to-come stable coin liquidity pool meant to ensure a stronger cross-chain peg for UST and others. The 4pool is to be a successor of the currently existing, similarly functioning 3pool.

It is further speculated that the attacker borrowed 100K BTC from Gemini ensuring enough liquidity to execute the coming attack and create the necessary shorts and long future positions to make it profitable. Summed up, the attack likely has a $4.2bn short position built on BTC and a 1$bn in UST. With this, the attacker sets the stage to create a run on the bank and earn money on his future positions.

In anticipation of the 4pool, LFG removes $150M from the 3pool liquidity on May 08 at 05:44. Very shortly thereafter, the attack uses $350M of UST to drain the remaining curve liquidity

This action only sent the UST peg to $0.972. As a response the LFG starts selling BTC to defend the peg, causing downward pressure on BTC while the run on UST was just getting started.

The attack then continues on the Binance exchange, where the remaining amount of the $1bn UST is offloaded. This attack triggers a panic wave amongst UST and Anchor users, causing the peg to spiral as low as $0.70 as people flee for the exit.

In the meanwhile, the LFG is selling more BTC and buying UST whilst the attacker is selling UST which could be an explanation for Bitcoin dropping 25% from $42k to $31.3k. The Terra chain then gets congested and several central exchanges suspend withdrawals of UST; which fuels the bank run panic even more before bottoming out at $0.60 on the 10th of May.

What then ensues is a continued battle between the UST algorithm, LFG, the attacker, and panic amongst many UST users. Luna is minted continuously in the battle and drops from an ATH of $40bn to $800m. It is speculated that the attacker should have been able to profit from an amount of $800m or more.

After a few days of mostly radio silence, Terra and LFG founder Do Kwon tweeted his plans to save the UST peg. In essence, the algorithm will be tweaked in a way such that Luna can be minted 4x as fast to buy up and burn UST 4x as fast. Whether this will save UST remains to be seen, we can only tell that these assets are currently very high-risk. Besides the obvious risk of Luna and UST, you should be mindful of other DeFi protocols that could be using UST or Anchor underwater to generate yield.

Conlusion

In conclusion, a potentially flawed algorithm, a big pile of lent money, willing attackers, and market fear caused the third biggest stable coin (and its backing token) to collapse heavily. However, the story is far from over. It will be interesting to see how Do Kwon's plan to reverse the free-fall of both UST and Luna will pan out. In the meanwhile, news has already reached US Treasure, secretary Janet Yellen, which today pushed for stable coin regulation by the end of this year. We will keep following the story and post updates as we receive new information.