Understanding UST Blockchain: Terra’s Algorithmic Foundation

UST Blockchain (TerraUSD)

The algorithmic stablecoin TerraUSD, also referred to as UST, was created to keep its value constant and was based on the US dollar. In contrast to conventional stablecoins like Tether (USDT) or USD Coin (USDC), which usually have comparable reserves of fiat money or other assets to support their value, UST maintained its peg by using a complicated set of algorithms and a dual-token system with its sister cryptocurrency, LUNA.

Core Mechanism: Algorithmic Stability with LUNA

Fundamentally, an arbitrage mechanism utilizing LUNA, the native token of the Terra blockchain, was used to keep UST stable. By automatically minting and destroying LUNA, the basic aim was to encourage market players to maintain UST’s price at $1. This technique, referred to as a “seigniorage” mechanism, was intended to maintain UST’s price stability by continuously balancing the supply and demand.

The mechanism functioned in two main ways:

Minting UST (when UST price > $1):

• To mint one UST, users might burn $1 worth of LUNA if the price of UST rose above $1, signifying great demand.
• After that, they may sell the freshly created UST for a profit (for example, if UST was trading at $1.05, they could profit by $0.05 per UST).
• The market would have more UST available as a result of this procedure, which might conceivably drive its price back down to $1.

Burning UST (when UST price < $1):

• Users could burn one UST to create one dollar of LUNA if the price of UST dropped below $1, which would indicate poor demand or excess supply.
• After that, they could sell the LUNA for a profit (for example, if UST was selling at $0.95, they could buy one UST for $0.95, burn it to get $1 worth of LUNA, and then sell the LUNA for a profit of $0.05).
• In theory, this procedure would push UST’s price back up towards $1 by reducing the amount of UST available on the market.
• At the same time, more LUNA would be available, which would drive down the price.

Key Components of the Terra Ecosystem

A number of essential components of the Terra ecosystem made it easier for UST to function and be adopted:

Terra Blockchain: This was the Proof-of-Stake (PoS) consensus-based blockchain network that served as the foundation for UST and LUNA.

LUNA Token: The native, erratic token of the Terra blockchain was called LUNA. Its main responsibility was to support the pegging system and absorb UST volatility. Voting on upgrades and ideas was another way that LUNA holders took contribute in government.

Anchor Protocol: A protocol for decentralized lending and borrowing based on the Terra blockchain. Anchor’s unsustainable high rates (around 20% APY) on UST deposits were a key factor in the adoption of UST. A large amount of UST was drawn to this, effectively locking up a sizable percentage of its circulating supply and generating fictitious demand.

Luna Foundation Guard (LFG): A nonprofit organization founded by Terraform Labs, the company that made Terra, with the goal of promoting the stability of the Terra ecosystem. LFG built up a sizable store of Bitcoin and other cryptocurrencies with the goal of supporting UST during periods of severe market stress.

Why UST Was Important

Due to a variety of factors, UST gained notoriety and emerged as a significant force in the decentralized finance (DeFi) sector. Prior to its final demise, it was frequently praised as a model algorithmic stablecoin.

Decentralization: UST was independent of banks and off-chain collateral, in contrast to centralized stablecoins like USDT or USDC, which are dependent on conventional financial institutions holding fiat reserves. The LUNA token and an advanced algorithm kept it completely on-chain. The DeFi community found this decentralized structure very appealing since it matched the fundamental values of financial independence from established institutions and resistance to censorship. Offering a stablecoin that is genuinely indigenous to the cryptocurrency ecosystem, this structure was regarded as a significant advance.

Interoperability: The smooth transfer and use of UST across many blockchains was made possible by Terra’s strong collection of blockchain bridges, including the Wormhole bridge and IBC (Inter-Blockchain Communication). Its broad adoption was made possible by this interoperability, which allowed UST to operate as a reliable and liquid unit of account and medium of exchange on Ethereum, Solana, Avalanche, Osmosis, and other well-known networks in addition to the Terra ecosystem. UST was positioned as a global stablecoin for the multi-chain DeFi landscape with this cross-chain usability.

Adoption in DeFi: Due in large part to the alluringly high interest rates provided for UST deposits, UST became extremely popular and deeply integrated into the DeFi ecosystem. This was especially true of the Anchor Protocol, which offered UST deposits an unsustainable but very alluring annual percentage return (APY) of about 20%. The market capitalisation and perceived stability of UST were greatly increased by this extraordinarily high yield, which attracted billions of dollars in UST and made it a leading stablecoin in a variety of lending, borrowing, and trading protocols across several blockchains.

Algorithmic Innovation & Scalability: A ground-breaking invention, UST’s algorithmic design employed LUNA as a counter-asset to keep its peg through mint-and-burn mechanisms. Because of this, UST was able to grow quickly without having to enrol conventional fiat collateral. Its audacious objective was to overtake fiat-backed stablecoins as the go-to decentralised stablecoin for savings and payments, providing a scalable substitute for centralised counterparts. Its perceived significance and promise were highlighted by its quick increase in market capitalisation.

Features of UST

The Fatal Flaw and Collapse of UST

Despite performing rather well in bull markets, the algorithmic process was incredibly susceptible to severe market stress and a decline in confidence. A “textbook example” of algorithmic stablecoin failure, the collapse happened quickly in May 2022.

UST’s de-pegging and “death spiral” were caused by the following events:

Initial De-pegging & Withdrawals: Massive withdrawals of UST from liquidity pools, specifically the UST-3pool on Curve Finance, occurred on May 7, 2022. This led to an imbalance and increased UST’s vulnerability to volatility. Due to a major sell-off that may have been sparked by a few big deals, UST’s price dropped below $1.

Arbitrage Fails & Panic Sets In: Traders started burning UST to mint LUNA as the arbitrage mechanism took over as UST started to de-peg. However, the supply of LUNA started to rapidly hyperinflate due to the enormous volume of UST being sold and burned, which caused the price of LUNA to fall. Massive sell pressure was created by the constant selling of LUNA in order to cash out the “arbitrage” profit, which further reduced its price. A “death spiral” resulted from this, whereby LUNA’s value plummeted as a result of UST’s de-pegging, making it more difficult to maintain UST’s peg, which in turn led to additional selling, and so on.

Anchor Protocol’s Role: A significant volume of UST was drawn to Anchor Protocol because of its high 20% APY. Users hurried to remove their UST from Anchor as soon as trust in UST started to wane, which increased the selling pressure on UST. A systemic risk resulted from the concentration of UST in Anchor because of the cascade effect of its abrupt withdrawal.

LFG’s Bitcoin Reserves Depleted: In an effort to protect the UST peg, the Luna Foundation Guard sold billions of dollars’ worth of Bitcoin from its holdings in order to repurchase UST. But LFG’s reserves were soon exhausted due to the enormous selling pressure, and they were unable to stop the trend. A wider decline in the cryptocurrency market was also influenced by this.

Exchanges Suspend Trading: As the crisis deepened, a number of cryptocurrency exchanges halted UST and LUNA trading and withdrawals, which exacerbated the panic and made it more challenging for consumers to sell their holdings.

Aftermath and Legacy

One of the biggest moments in cryptocurrency history occurred in May 2022 when TerraUSD and LUNA crashed, wiping out tens of billions of dollars in market capitalisation and creating massive losses for investors.

Increased Scrutiny on Algorithmic Stablecoins: Due to its reliance on market dynamics rather than physical collateral, many experts now consider algorithmic stablecoins to be intrinsically hazardous, a position that was heightened by the occurrence.

Shift Towards Asset-Backed Stablecoins: Fully collateralised stablecoins, such as USDT and USDC, which hold reserves in conventional assets, have seen a notable increase in investor preference.

Terra 2.0 and Luna Classic: Terraform Labs introduced the Terra 2.0 blockchain and the LUNA token in an effort to revitalise the ecosystem. TerraClassicUSD (USTC) was the new name for the de-pegged UST, whereas Luna Classic (LUNC) was the new name for the original LUNA. These new tokens have had difficulty regaining their previous level of significance, though.

In short, TerraUSD’s rapid demise was caused by its creative but ultimately poor design, unsustainable high profits via Anchor Protocol, and insufficient collateral to withstand a “bank run” situation. The dangers of some forms of decentralised finance and the significance of comprehending the fundamental workings of cryptocurrencies are both sharply brought to light by this.

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