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Deep Dive: UST/LUNA Explained and The Future of Stablecoins

By Marthe Naudts and Florent Jouanneau, White Star Capital

Cryptocurrencies are known for their propensity for volatility. It’s a defining feature of the asset — a feature, not a bug. But in the last two weeks, the ironically named stablecoins — intended as more of a functional asset to hedge against the inherent price fluctuations from crypto demand and supply — have sent shockwaves through the crypto ecosystem, as the collapse of UST/LUNA resulted in the greatest cause of volatility in the last few years in crypto. The extraordinary crash and its aftermath has been a case study for how a stablecoin should not work, and more generally puts into question — what does the future look like for stablecoins?

Stablecoins and Crypto Ecosystem

Stablecoins are cryptocurrencies that are pegged to the reference price of a reserve asset, often to the US dollar, allowing users to preserve fiat value without having to cash out. This means having a medium of exchange to pay for goods and services, allowing users to benefit from the functionality of crypto and blockchains without the volatility that comes with unpegged cryptocurrencies like BTC and ETH.

Traditional means of sending and receiving fiat currency involved intermediaries — usually banks — who charged expensive fees for an outdated and convoluted process of moving funds. Stablecoins enable users to bypass this global fiat banking payments system and send coins with fiat value, instantly and cheaply. They’re often used as collateral in crypto lending and borrowing protocols, making them (and their associated stability) a critical and foundational technology of DeFi. The entire principle is that they are stable by nature of design.

Stablecoins Market Cap (Defillama — 19 May 2022)

Since May 7th, the crypto world has been heavily shaken, as Terra, the second largest ecosystem in DeFi in terms of value locked, crashed. Its algorithmic stablecoin, UST, depegged and, along with its sister token, LUNA, entered the dreaded and ominously named ‘death spiral’. From recent highs of over $100, UST fell to around 12 cents, while LUNA crashed towards zero, erasing about $45bn in wealth in the process. It’s difficult to understate the significance of this for the crypto ecosystem given how dependent the viability of decentralized systems is on user trust and confidence. Evidence of systemic risk is seen at every level — BTC and ETH reached their lowest points since 2020, with altcoins like Dogecoin and Cardano faring worse, and other decentralized stablecoins like Neutrino, Celo Dollar, sUSD, and USDT all having found themselves below the $0.98 mark at various points as consumer confidence faltered. Just this week, DEI, a crypto-collateralized stablecoin created by crypto trading platform Deus Finance, crashed to 52 cents.

This all comes amid increasing talk of government intervention, as the Federal Reserve released a report last week suggesting tighter regulation and US Treasury Secretary Janet Yellen commented that tighter regulation would be ‘highly appropriate’ in a testimony to the Senate Banking Committee. UST’s depegging, she continued, ‘simply illustrates that [stablecoins are] a rapidly growing product and there are rapidly growing risks’. Given the failures of private leadership and on-chain governance in the past weeks, regulation is certainly necessary — but the best form of which remains up for debate both within and between the crypto community and the Capitol.

So what happened? Well, let’s first take a step back and start with how exactly stablecoins work.

There are three types of stablecoins

A resilient stablecoin is one that has 1) scalability and 2) utility — these are mutually reinforcing. The point is, if the stablecoin is in wide enough circulation, there is enough liquidity to maintain the stability of the coin as arbitrageurs will keep seeking out differences from the peg and continuously buy and sell, keeping the market efficient. This ability to continuously buy and sell depends on its scalability and utility.

These two characteristics are achieved through a) enough use cases for the stablecoin, b) enough user confidence in the coin and the pegging mechanism, and c) enough backing with the underlying asset. Again, these are mutually reinforcing.

These traits and their trade-offs vary depending on the type of stablecoin. Though the exact stability mechanisms in place vary with each and every coin, one can generally pool them into three buckets: fiat-collateralized (IOU), crypto-collateralized, and algorithmic.

Fiat-collateralized (USDT, USDC)

Fiat collateralized stablecoins are custodial coins requiring backing with off-chain collateral assets (often fiat US dollars) as reserves that sit in a bank. They are by far the biggest class of stablecoin. The largest is Tether (USDT), a stablecoin pegged to the dollar, and described as backed 100% by Tether’s reserves. with a market cap of over $73bn. USDC, issued by Centre (a joint venture between Circle and Coinbase), is the second-largest, with a market cap of over $42b. Its reserves roughly split into 23% cash, 77% US Treasuries. Tether, in contrast, has notoriously failed to be transparent with its reserves and operations (see here, for example), although it has recently re-affirmed its reserves in a report found here.

In most cases, the reserve ratio is 100% — the stablecoin developer owns reserves exactly equal to the amount of stablecoin in circulation, meaning each coin is backed one-to-one with a unit of the reserve asset. For example, every time someone purchases 1 USDC for 1 dollar, Centre stores the dollar for future holders to redeem in exchange for selling it back.

Fiat-collateralized stablecoins are as stable as USD and can handle periods of rapid or extreme price fluctuations because each issuance is backed by an overcollateralized debt position. As functioning stablecoins, they are the gold standard (literally).

Now, of course, the reserves backing the circulating supply are subject to the verification and custody of centralized parties. For example, Circle and Coinbase have governing control over USDC, Signature Bank stores the fiat collateral, and Grant Thornton LLP, a US-based accounting firm, audits the reserves. This means they come with all the problems associated with intermediaries that blockchain maximalists believe defeat the entire purpose and appeal of cryptocurrencies. These problems include counterparty risk (e.g. the threat of government seizure, theft, fraud), and censorship risk (e.g. the threat of governmental or regulatory action).

For most, this is not the main concern — in fact, the problem is rather the opposite. To reiterate, this system requires a willing intermediary, typically a bank, to store the fiat assets that collateralize the coin/token. Without paying banks to do so, there is no reason why they might be incentivized to facilitate a currency that ultimately competes with their banking-rail-enabled fiat equivalents. Without introducing much larger fees, which defeats most of the appeal in the first place, this mechanism is therefore unlikely to scale enough to be the payment solution for a global parallel Web3 economy.

Crypto-collateralized (DAI)

The second category of stablecoins are those overcollateralized with other cryptocurrencies. The most popular is MakerDAO, an Ethereum-based protocol, which has two currencies — MKR, a governance token, and DAI, a stablecoin backed by ETH. DAI is minted on the MakerDAO protocol by depositing collateral in the form of Ether and Bitcoin. The collateral is set by a smart contract that ensures that a threshold of ETH is pooled before users can mint DAI. Maker algorithmically liquidates pledged collateral to satisfy DAI loans in line with the price of ETH as it declines or rises in USD value.

Like the fiat-collateralized, this custodial system is robust and has more or less maintained its peg through numerous BTC and ETH price crashes. However, once again, the collateralization is both its purpose and its downfall.

Collateral is even more of an issue in crypto-collateralized stablecoins than in fiat-collateralized stablecoins because of rapid and extreme fluctuations in crypto prices. For example, let’s say a borrower deposits $100 in ETH for a loan of 100 DAI. What happens if the price of ETH then falls considerably? The collateral is wiped out and the lender is likely to suffer a loss, and naturally (given this not being unlikely in the inherently volatile crypto world) the lender anticipates this risk an is disincentivized to offer the loan in the first place. To mitigate this, DAI and other crypto-collateralized coins are always overcollateralized to provide extra insurance for this price volatility. If, when the price drops, users fail to add additional collateral to meet the ratio set by the smart contract, they risk liquidation of their position.

Once again we run into the problem with this system at scale. Crypto-collateralized stablecoins cannot be the payments system underpinning a Web3 world, because it drains a significant amounts of liquidity and collateral from the crypto ecosystem.

Algorithmic (USDD, UST, DEI, Basis)

Non-collateralized stablecoins use algorithmic expansion and contraction of supply by burning or minting new coins based on fluctuating demand, in order to shift the price to the peg. This means that they approximate the value of the US dollar, but don’t hold US dollars. UST was the largest, but other examples include USDD, recently unveiled by Tron.

Every algorithmic stablecoin has a mint/burn dynamic between governance tokens and their associated stablecoin. For example, in the same way as LUNA/UST, Tron’s peg relies on incentivizing arbitrageurs with trading between TRX, Tron’s token, and USDD. All stablecoins using this mechanism are at risk of the pegged stable trading below its fiat peg and instigating a ‘death spiral’ whereby increasing amounts of the governance token is minted, driving its price down and requiring even more of it to be minted to maintain the 1:1 relationship with the stablecoin.

Due to this design, algorithmic designs are significantly more scalable, but less resilient to extreme fluctuations, leading to periods of extreme volatility that erode confidence in their utility as stablecoins in the first place. Moreover, their mint/burn dynamic without underpinning reserves leaves them all vulnerable to the ‘death spiral’. Basis was the original algo-stablecoin that fell victim to this (see here) but since then many others also have, including of course UST, leading many investors to become disillusioned with the hopes that this design resolved the issues of its collateralised counterpart.

Hybrid (FRAX)

Hybrid stablecoins might be the preferred model because their hybrid approach avoids the problems associated with pure algorithmic and pure collateralized models. Pegging to the USD through a mostly algorithmic mechanism, but with reserves available, means that the collateral ratio can change to handle periods of volatility or more extreme periods of market demand.

Frax has proven to be one of the most dominant of these designs so far. FRAX is the stablecoin associated with the Frax fractional-algorithmic stablecoin protocol, and FXS is its utility token which manages the protocol and revenue generated. While Frax is algorithmically pegged to the USD, they also have enough reserves available to handle periods of volatility and market demand. Although UST/LUNA had a similar model, we will see how their reserves were insufficiently built up and deployed, so the key word here will be ‘enough’.

So how does it work? Put simply, Frax has portions of its supply backed by collateral, and portions being unbacked/floating. The key innovation is that Frax is an agnostic protocol — it allows for the collateralization ratio to be determined by the market. The ratio of collateralized to algorithmic depends on the market pricing of $FRAX — increasing if $FRAX is trading below $1 and vice versa. If FRAX falls below $1, the collateral ratio increases until confidence is restored and the price recovers.

The automated movement of FRAX and its collateral is done by Frax’s algorithmic market operations modules — AMOs. If FRAX demand increases, AMOs programmatically leverage idle collateral, moving it to capital-efficient locations. Because the Frax design means that its reserves are at work in other protocols when they are not required, they essentially generate yield on their reserves, which then adds to the collateral available. ****Some key AMOs used by Frax include Collateral Investor AMO, Curve AMO, Uniswap v3, and FXS 1559. Of these, the Collateral Investor AMO has accrued most of the generated profit for Frax finance and is explained below.

💬 “The Collateral Investor AMO puts idle USDC collateral from the Frax treasury to work across several DeFi protocols such as Aave, Compound, and Yearn. This AMO will loan out or reclaim collateral automatically as the collateral ratio changes. As the collateral ratio lowers and more of FRAX is backed algorithmically, the Collateral Investor AMO will automatically send collateral to the aforementioned protocols to generate additional yield on its USDC for veFXS holders. If the collateral ratio rises and more collateral is required to back FRAX, the Collateral Investor AMO will work in reverse and pull collateral back to the Frax treasury in accordance with the collateral ratio that the market deems necessary to keep confidence in Frax. Since implementation, the Collateral Investor has accrued $63.4M profits for veFXS holders.”

- [Messari, February 2022]

Frax has held up remarkably well, not diverging too far from $1 even throughout the UST crisis. We will return to it after addressing what it is being compared to.

Price of Frax 25th April — 16th May

LUNA/UST — What happened?

UST is the algorithmic stablecoin created by TerraformLabs. Do Kown, Terra’s bombastic founder, called the stablecoin ‘my greatest invention’, even naming his newborn daughter Luna. He proudly hyped ‘Lunatics’ and rallied community sentiment in typical crypto style — trolling on Twitter. When criticised, he fell back to dismissal, taunting naysayers with tweets like ‘I don’t debate the poor’.

VCs lapped it up, as Terraform raised more than $200m from firms like Lightspeed Venture Partners and Galaxy Digital in a frenzy of excitement over the future potential of algo-stablecoins, without necessarily considering how robust the underpinning mechanism was.

So did retail investors, pumping money into USD as Luna’s total value ballooned, reaching a market cap of over $40bn. As its price rose from $1 in early 2021 to a peak of $116 in April, many reaped huge profits. This only served to feed into the Lunatic frenzy.

But it only took a matter of days for it to all fall apart, and by May 13th Do Kwon’s ‘greatest invention’ collapsed to worthless. Although many institutional investors caught on earlier and sold off their holdings, retail investors were left to suffer huge losses. From its peak of $116, Luna is now trading at $0.0001.

Price of Luna
Price of UST

How was the LUNA/UST stabilization mechanism meant to work?

The Terra blockchain natively produces LUNA governance tokens, which can be burned to mint UST, its algorithmic stablecoin. Users can burn one UST for $1 worth of LUNA. Always. If LUNA is at $100, you can redeem it for 100 UST, or redeem $100 UST for 1 LUNA. The peg is maintained by the incentives induced by this algorithmic market module: even if UST is worth less than $1, arbitrageurs can buy it and redeem it for $1 of LUNA.

So what is Luna used for if its only purpose is to absorb UST volatility? Well, there are three main use cases. 1) LUNA can be used as collateral for other protocols, 2) it can be sold for other cryptocurrencies, or 3) it can be burnt for more UST if you believe the price of UST will increase again. The price of UST eventually should revert to the $1 peg because burning UST reduces its supply, thereby, through basic axioms of supply and demand, increasing its price.

Now, UST is supposed to remain around $1, whereas LUNA can be volatile. In principle though, they should move together in that if demand for UST increases, demand for LUNA does too. As noted, LUNA’s entire purpose is to absorb UST volatility. However, if LUNA’s price does not increase sufficiently with UST market cap expansion, then over time UST essentially becomes less ‘backed’ by LUNA. In other words, if the market cap of UST is higher than the market cap of LUNA, UST is less and less backed. This is exactly what happened. As seen below, the market cap of UST continued to rise, and from its peak ratio of 635% in November, it fell precipitously to 149% in May.

TerraUSD Market Cap

To better match the remaining UST demand, Terra established the Luna Foundation Guard, which was a reserve to exchange UST with other cryptocurrencies, notably Bitcoin, instead of Luna. In its own words:

💬“In an event where the market price of UST materially deviates from the USD peg, holders of UST will be able to close the arbitrage and bring the market price of UST back to the peg by swapping UST for major, non-correlated assets like BTC that capitalize the reserve. The reserve functions as a release valve for swelling pressure to exit UST to LUNA on-chain, dampening the reflexivity of the system by reducing the dilution of the LUNA supply during severe contractions and restoring the peg in real-time and maintaining an alternative arbitrage opportunity outside of the Terra protocol itself.”


Crucially, however, LFG never had enough reserves to match all UST. At the time of the UST depegging, LFG had approximately $2.3bn in cryptocurrency reserves, which was meant to supplement the Luna supply to meet the total UST supply.

The primary driver of demand for UST was the Anchor protocol, in which users can stake UST for 19.5% yield. A very large proportion of UST’s circulating supply was deposited in Anchor, reaching as high as over 70%, around $14bn, before it depegged. The 19.5% APY was supposedly sustainable on the basis of a positive yield reserve, which is a combination of 1) the interest rate paid by other users borrowing UST, and 2) the yield generated by the assets used for collateral. We shall see later how this contributes to the death spiral.

What went wrong?

Curve is the largest protocol in DeFi by TVL. It is an exchange liquidity pool on Ethereum allowing stablecoins to be traded for one another with low slippage. It is the primary hub of stablecoin liquidity on Ethereum, and the pool is usually balanced in equilibrium supply of each coin (all of which are meant to be pegged to $1 and so all are theoretically tradeable for one another at a 1:1 rate). It currently has about $8.9b total value locked (down from highs of around $24b in January). Because of how large the liquidity pool is, the prices on Curve become the reference price on other protocols.

On May 7th, over $2bn worth of UST was taken out of the Anchor Protocol, and hundreds of millions of that was immediately traded in Curve for other currencies. It is an ongoing source of debate whether this was a more malicious attack on Terra, but presumably, it was at least partly due to the view that the 19.5% yield on Anchor, the ratio of UST to Luna market caps and the insufficiency of LFG reserves all meant that the UST pegging mechanism was ultimately unsustainable.

Curve Dispersion

Either way, this huge sell distorted the balance in the curve and pushed down the price of UST to 91 cents. UST must be absorbed if it is to remain pegged. But trading within the pool (i.e. trading UST for DAI/USDT/USDC) would incur impermanent loss because the distortion in supply meant that the coins are no longer all worth $1. Exchanging for LUNA was therefore the more profitable and feasible option. So, as per the stabilizing mechanism described above, arbitrageurs immediately wanted to exchange 91 cents worth of UST for $1 worth of LUNA.

As the supply of LUNA shot up, its price dropped. As more caught on to the price collapse, there was less demand for LUNA, since its use cases relied on either being exchanged for UST (no longer in demand) or as collateral (which relies on it being a stable asset, which it no longer was). In other words, normally increasing the supply of Luna would not necessarily drop the price because it could be used for the use cases outlined above, but because of the speed and volume of the transactions, the market did not have time to adjust and so it became more difficult to sell off this new supply in LUNA.

The problem was, due to LUNA’s decreasing price, as more and more UST was burnt, an even larger amount of LUNA had to be minted, increasing the supply exponentially.

Now, the idea would normally be that LFG reserves could buy up the UST instead, but remember that LFG reserves were less than the total UST. Investors are therefore left with a depegged UST until LUNA minting matched the UST selling.

The pegging system is fundamentally a procyclical amplifier mechanism. This means that when such a knock occurs, inevitably we enter a negative feedback loop — the death spiral — without enough reserves to cut it out.

On May 6th, UST was stable at $1. The following week it went on to bounce between 30 and 60 cents in the first week following the initial depeg, and reaching lows of 0.05 two weeks later. LUNA holders fared worse, often locked up from having staked their coins. They were trapped as total supply reached 6.91 trillion, and the price of LUNA crashed to $0.0001, compared to peaks of $120 in April.

Catastrophic management failures

Do Kwon has been intensely criticized for his lack of adequate or timely response. Not only did he fail on a practical level to effectively mitigate the disaster, but he also more generally demonstrated an inability to effectively lead in an industry highly dependent on community sentiment and confidence.

Before laying out the makeup of its funds on Monday 16th, there was little transparency over how the catastrophe was being managed. Some questioned how the LFG used the reserves it said it did — around $1.6b was inexplicably sent from LFG’s wallet to Gemini, a crypto exchange on May 9th, and another $875m was sent to a Binance wallet. It was initially difficult to verify what happened from there, contributing to faltering confidence and coin dumping.

“Where is all the BTC that was supposed to be used as reserves? Shouldn’t those BTC be ALL used to buy back UST first?”

Changpeng Zhao, Binance Founder-CEO

Although the situation is still playing out, the damage is mostly done. Opacity goes against the culture of Web3 and DeFi, and the delays in communication led to more market frenzy over the weekend than was necessary.

Do Kwon is now facing prosecution in South Korea for fraud and other financial regulation violations (see here), and, given his attitude prior to and during the depegging, is facing extreme backlash from within and outside the crypto community.

What solutions are being suggested?

1) Fork the Terra Blockchain

On Friday, May 13th, Do Kwon proposed that “The Terra community must reconstitute the chain to preserve the community and the developer ecosystem”, ie. taking a snapshot of current Luna and UST holders, creating a new blockchain, and distributing 1bn tokens among various stakeholders from this group. 40% of the tokens would go to LUNA holders before de-peg, 40% to UST holders pro-rata at the time of the new network upgrade, 10% to LUNA holders before chain halt and 10% to the “Community Pool to fund future development”. This would amount to resetting the blockchain to its state before the pegging.

On May 18th, this suggestion was formalized into a proposal on Agora to fork a new Terra Blockchain,(and rename the existing network Terra Classic and Luna Classic, $LUNC). Below is the status of votes as of May 21st.

This is unlikely to work given that this new fork has no intrinsic value (remember the need for utility and scalability, and everything required for that?) — because consumer confidence is entirely wiped out. As Binance CEO, Changpeng Zhao, pointed out, all it achieves is diluting the existing coinholders. Incentives are just a bootstrap mechanism, not underpinning forms of value.

What likely explains the vote is that Luna holders believe it’s the best hope they’ve got of getting some of their investment back, rather than reflecting any widespread belief that this new chain will replace and continue as a successful forked version of Terra before the de-peg. It would not be surprising if the same death spiral played out on the new chain was this to go ahead.

2) Raise funds to purchase enough UST to bring it back to peg

At this point, it’s unlikely that LUNA can be salvaged, and so it could be sacrificed and used as exit liquidity to restore the UST to its peg. In this case, Terraform Labs and the Luna Foundation Guard will need to raise enough capital to purchase and then lock up enough UST to do so.

LFG tweeted on Monday 16th that it had depleted its reserves to 313 Bitcoins, down from more than 80k on May 7th. Analysts at the Block calculated this meaning its reserves had depleted from a value of $3.1bn to about $87m. As explained, it was unclear exactly where their reserves have gone but it has since become clear that this was an attempt to gather enough capital to make UST holders whole again.

The broader point is that to salvage the peg, LFG and Terra will need capital and a lot of it. It is still up in the air how exactly they’ll look to achieve this.

This proposal on the official Terra forum explains how to maintain the peg, should it get restored:

💬 “1. Limiting the amount a wallet can hold / transfer. Transactions exceeding this chosen amount will be declined. Users may request for an increase to their wallet transaction limit, by a public governance vote. Allowing for a public available list of wallets and their adjusted limits. This will allow Terra and trusted partners not be restricted while limiting external users to not move the market significantly.

2. The locked UST from the fund will generate a % yield overtime, that may be distributed to UST holders/wallets that lost funds during the attack. This will incentivize existing holders to return to the terra ecosystem and restore trust. See this 20 forum for further reading to a potential repayment system.

3. UST and LUNA will need a system to ensure the imbalance of market cap between the two is managed. This may be done by incentivizing holders of one to convert to the other and by UST % yields / LUNA staking rewards to increase / decrease dynamically.

4. Adjust the Mint / Burn market maker to ensure UST peg is promptly stabilized back to peg, this will ensure trust is not lost when the peg is not maintained for prolonged periods.

5. Overtime Terra and the many projects generate a revenue and a percentage should be distributed as collateral and held in a different assets [gold, stocks, stablecoins, other projects, BTC etc]. Having collateral distributed in different assets protects the trust of Terra while certain markets lose value”
- [Source]

Assuming the ability to raise capital is limited, returning a set amount of dollars to each UST in every wallet would disproportionately return funding to rich whales. Indeed, out of a total of 256k Anchor wallets, the top 1000 own 82% of all UST.

Another suggestion circulating on the Terra forum suggests allocating capital to make smaller wallets ‘whole’ first, to prioritize community sentiment. Such a tiered repayment system, proposed by FatMan, would ensure smaller wallets are prioritized. With their current $1.5bn fund, Terra could make the return on every dollar invested by the smallest 99.6% of wallets.

The benefits of this are not just the ethical value — community confidence and sentiment is extremely important for maintaining value within crypto communities. LUNAtics were one of the strongest online communities, fervently defending the Terra blockchain and supplying it with enough liquidity to uphold the peg even when the inherent value derived from use cases was yet to catch up. Restoring this community faith will be key to maintaining the peg and prioritizing the mass of smaller investors, who are harder hit by the losses, is one important way of doing so if funds are limited.

Final thoughts: what are the long-term takeaways for the crypto ecosystem?

Although events have yet to fully play out, the far-reaching consequences of Terra’s collapse cannot be understated. LUNA was supposed to be a blue-chip stablecoin and Anchor was (a priori) a state of the art DeFi protocol. The effects of this collapse hit at every level of the crypto ecosystem.

Fiat pegged tokens are tokens that are fundamental to DeFi given their role in key protocols like lending and borrowing. The development of a sustainable, scalable stablecoin with a safe and reliable pegging mechanism is absolutely necessary to the future of DeFi and the flourishing of the crypto ecosystem more generally.


As we’ve seen, a lot of people have lost a lot of money. The immediate need is to pick up the pieces and begin to recover huge losses that some faced from having outsized proportions of their portfolio in one or related assets.

As mentioned, LUNAtics had one of the strongest community sentiments in crypto. This shows the significance of independent research into consumer investing, and the dangers of blind cult following. No coin is too big to fail, and no personality is big enough to uphold it. Unsustainable promised APY rates for minting stablecoins with insufficient reserves should always be suspicious, no matter how strong the community. One of the most important takeaways from this is that stablecoins need to have intrinsic value through use cases, accountable issuers, and valuable underlying assets.

Relatedly, stablecoins (due to their inherent links to other coins and their use in other protocols) are also big contributors to systemic risk. As seen in the current bear market, contagion from the collapse of Terra spread throughout the digital asset ecosystem, with everything from altcoins to bitcoin taking a hit from investor malaise. Bitcoin, for example, fell on May 12th to below $26k — its lowest price since December 2020.

This also demonstrates the significance of adequate governance. On-chain governance clearly failed, both at building up and deploying the reserves, and at providing and communicating the swift decision making required to manage this crisis. We are well overdue a broad re-evaluation of what regulation can be implemented that protects individual investors without defeating the purpose of decentralization.


The failure of the UST/LUNA stabilization mechanism ultimately comes down to its non-collateralized design. UST was majority backed by an asset in freefall, for which there was no demand, and there were not enough BTC/other reserves to absorb the sell pressure in time.

Similar algorithmic models like USDD which also rely on incentivizing arbitrageurs to trade with a native government token are now highly questionable since if the governing token loses value due to increasing supply, the death spiral ensues.

As we’ve seen, however, collateralized stablecoins also have key flaws which leave them incapable of being the backbone currencies of the web3 economy that we ultimately want and need them to be. So is there no future for any of the models?

Well, as we saw, UST/LUNA worked well with its first layer of depegging protection, until the death spiral, at which point its second layer of protection — its reserves — were no longer sufficient. But were we to have a coin that cracked the second layer, in such a way that the majority of the time it could still rely on the first, we could avoid the spiral. Frax and hybrid models are the closest we currently come to this, as their collateral dynamically varies with the supply and demand in the market, and their stability proves this point.

This brings us back full circle to the different types of stablecoins and their pegging mechanisms. Having multiple designs is crucial to diversifying and derisking Web3 ecosystems. But after the collapse of UST/LUNA, the need for innovative hybrid models beyond pure algorithmic or pure collateralized has proven out to be necessary for long-term, capital-efficient stablecoin creation and allocation. We look forward to any and all innovation in this space.


The Content of this research publication is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.




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