The Fundamental Reason Why UST Collapsed (Important Lesson for Stablecoins)

A harsh reality in crypto is that many of the leading stablecoins today are a lot more unstable than they claim to be.

Last year’s catastrophic UST crash was a quintessential example of how vulnerable some "stablecoins" actually are.

Despite claiming to be a secure stablecoin, massive oversights in the architecture of terraUSD (UST) led to one of the biggest crashes in crypto’s history.

Here’s why that happened.

UST and Luna lost billions in value

For years, many experts in the crypto landscape had warned of an upcoming UST collapse, and the consequences that it could have on the industry.

Sure enough, that happened in May of last year. At the time, UST boasted a market cap of around $18 billion USD. 

Despite claiming to be pegged to the price of 1 USD, the asset’s price fell to just 35 cents on May 9th. 

UST was supported by LUNA, an additional asset in the Terra ecosystem designed to help UST maintain its $1 peg. This asset, however, did not fare any better.

Despite being valued at $80 USD per coin prior to the massive UST crash, LUNA was worth just a few cents days later.

In a final effort to save the UST, close to $3 billion USD in bitcoin was sold. Unfortunately, this fell short of stopping the downward spiral of both UST and LUNA.

UST and Terra were Undercollateralized

For anyone keeping a close eye on the Terra USD (UST) and Terra (LUNA) situation, an impending crash seemed obvious. For many, it wasn’t a matter of if, it was a matter of when.

Fundamentally, the core warning signs that UST was not as stable as it appeared to be were the exact same reasons why the asset inevitably crashed.

Terra USD’s supposed 1:1 peg with the US dollar was tied to Bitcoin reserves. But despite a market cap of $18 billion USD, there was reportedly only $4 billion USD worth of BTC held in these reserves.

In other words, UST was severely undercollateralized.

The Terra ecosystem also offered a return on investment that was simply too high to be sustained by its liquidity, which was low in comparison to the yield UST offered. 

These factors made UST extremely susceptible to collapsing in on itself.

This came to a head when two trades broke UST’s peg. While the team succeeded at temporarily mitigating the vulnerability this created, they were unable to stop the massive sell-off that soon followed.

To best understand what happened, we can compare the situation to crypto’s version of a bank run. 

Here, the ecosystem's already-low liquidity was exasperated by people attempting to cash out. This created even more panic, causing even more people to try and get their money out at any price point they could.

To try to stop UST’s crash, many exchanges stopped allowing users to withdraw their tokens. However, this did not stop people from burning their UST to claim $1 USD worth of LUNA. 

The result was one of the largest and most consequential crashes in crypto’s history.

Why True Stablecoins are Immune to this Issue

The core lesson of the UST crash is one of caution. The crypto community itself needs to be more cautious with the project it supports, and project teams need to be more diligent in avoiding the circumstances that led to the UST disaster.

True stablecoins need to follow the core tenets of security and decentralization.

One of the most important tenets of all is that any stablecoin needs to be sufficiently collateralized—ideally overcollateralized—at all times.

When an ecosystem is overcollateralized, it means that it can comfortably withstand a nightmare scenario in which all users attempt to withdraw their money at the time. In other words, being overcollateralized can make a system immune to bank runs and the kind of panic-induced crash that took down UST and LUNA.

USDL is an example of a true-stablecoin that is always overcollateralized. 

With USDL, anyone can instantly redeem $1 USD worth of PulseChain’s native asset, $PLS, at any given time. Since the protocol is always overcollateralized, the protocol can comfortably handle this demand without compromising its peg to the USD. 

In order to ensure that USDL is the true stablecoin that the ecosystem needs, the Liquid Loans team spent years pursuing a cautious development path that prioritized perfection above everything else.

The protocol was audited by a leading cybersecurity company called Halborn, who conducted a thorough independent investigation in order to ensure that USDL is the robust stablecoin it was designed to be. 

USDL is set to usher in a new age of truly-secure stablecoins.