It had to play out sooner or later: the moment that stablecoin US Terra (UST) would face a stress test. It happened during the current price drop of the crypto markets. At its low point, UST was worth only about 65 cents. At this writing, the price is about 90 cents.

-- Published on May 10th. This is an ongoing story, new facts are constantly emerging --

It is not the first time an algorithmic stablecoin has lost its stable value (peg). Nor is it the first time that UST itself has run into trouble. Previously, this happened in May 2021. Then the peg was restored within a day. However, it is the first time the peg has been lost of a stablecoin that has such a large market value: about 18 billion USTs are in circulation. UST was the third stablecoin before the price drop and is now number four - that's because of the price drop. It should become apparent in the coming hours and days how well the crypto markets handle this.

A death spiral

The first warning signs of a crash came last weekend. And then, when crypto markets fell across the board on May 9th, LUNA's price drop did the rest. This made UST extra vulnerable. Because LUNA acts as a stabilizer of UST's price, a problem arises when people start ‘running for the exit’. Because if the price of LUNA drops hard, it becomes difficult for the Luna Foundation Guard (LFG) to replenish the coffers of the Anchor Protocol. And those funds are needed to make possible the 19% interest that depositors get on their UST. And when they see the chances of their high interest evaporate, they start selling their UST for LUNA, after which they dump that LUNA on the market... a death spiral.

The LFG saw this scenario coming, of course. It has wanted to prevent the death spiral scenario by building up a buffer of mostly Bitcoin in recent weeks: over 40,000 Bitcoin. They can sell those in case of emergency and buy back UST. (That puts pressure on Bitcoin's price in a market period that was already difficult. Still, the billion or so dollars of BTC are probably not enough to make a huge difference - unless that amount is dumped on the market tremendously fast).

The question is whether it is enough. It is still possible that UST crawls back to $1. In any case, many people’s hopes of the viability of an algorithmic stablecoin will have been crushed.

Criticism from insiders and regulators

Undoubtedly, regulators will use the UST issue as an opportunity to crack down on certain stablecoins. Perhaps Paxos and USDC will benefit: they are in the best position with regulators because they have to be transparent about their reserves.

Also in crypto circles, a lot of people will be a lot more vocal against Terra's model of stablecoins. Unlike stablecoins USDT and USDC, which have reserves in real dollars, UST was backed by only crypto. But isn't this a noble goal: to not want to build your stablecoins on the traditional financial system? According to many in the crypto world, no: they think UST is a ponzi scheme in which founder Do Kwon has assumed far too much power of something that is supposed to be ‘decentralized’.

This happens in all markets

It's a bloodbath but we have to remember that this kind of thing happens in traditional markets too. There too, currencies are tested and attacked. Notorious is the Breaking of the Bank of England by George Soros, who attacked and successfully devalued the British Pound. He, of course, made a profit from this himself. Short sellers are also behind this attack on UST, it is claimed. But short sellers can also be squeezed... to be continued.