The risk of algorithmic stablecoins - Case example UST (TerraUSD)

5 min read
May 12, 2022 10:21:05 AM


This week the crypto space experienced a heavy setback. UST, the algorithmic stablecoin de-pegged from the 1 Dollar mark and is currently trading below 0.5 US Dollar (12.05.2022) while Luna has lost more than 99% of its value. Before USDT had a market cap of 18.6B and Luna of 30B. It has devastating consequences for the crypto space, especially for UST holders, who expected UST to remain equal to the value of 1 Dollar and Luna holders. UST was launched in September 2020 and the concept worked well until a few days ago. What happened and why do algorithmic stablecoins carry substantial risks?

In this blog post we explain to you what stablecoins are, the meaning of algorithmic in the context of stablecoins, the recent events in relation to UST and to what extent CoinRisk can help you identify and mitigate risks around DAOs and Tokens.

Definition & Purpose of Stablecoins

First of all, let’s define what a stablecoin is: The purpose of a stable-coin is to remain its value supposedly stable as the name indicates. The most common stable-coin type is a pegged stablecoin like USDT. If the stablecoins are off-chain fiat collateralized, funds backing stablecoins are held in a reserve by an issuer or custodians for preservation. The value of the stablecoin is maintained based on a 1:1 ratio of the US Dollar. This is enabled by oracle price feeds that allow to load off-chain data such as the US Dollar to smart contracts. Exchanges can either have their own oracle price feeds or use APIs to import the data from other providers. The companies issuing the stable-coins claim that they always maintain the same amount of the minted stable-coin in US Dollar in their reserves. They should hire independent auditors to verify the reserves in their treasury. For example, the company which issues USDT, can be accused of not holding 1:1 reserves in their treasury once in a while. This can have an effect on the short-term price development of the stable-coin as many holders lose trust at the same moment and start panic selling. In theory, selling for fiat money would mean that the stable-coins are burned by sending them to a smart contract while the seller would receive the equal amount minus the fee in US Dollar. However, in practice, most stable-coins are traded by users on exchanges on which orders are matched. Thus, it happens sometimes that users pay a premium on the price, if the market is illiquid and sellers ask for a higher or lower price compared to the real currency.

Algorithmic in the context of stablecoins

So what is an algorithmic stablecoin? An algorithmic stablecoin ensures stability by pegging the price of a reference asset leveraging algorithms and market incentives. In theory, this allows the supply of stable-coins to be adjusted and consequently, to direct the price more or less to the desired value. It requires a minimum level of demand for the ecosystem to operate. Some algorithmic stable-coins maintained the price well for a short amount of time, but  failed catastrophically due to the lack of consistent demand for operational stability and independent actors with market incentives to perform price-stabilizing arbitrage. Once confidence and trust are lost, algorithmic stable-coins such as the case example NuBit with its drop in March 2018, struggle to maintain the price at par value and get trapped into a death spiral with the value converging to zero. However, this does not mean that it will always be destined to fail as technology, algorithms and price feeds will become more advanced and instantaneous. Another algorithmic stablecoin called DAI has managed to keep its value close to the US Dollar. In this case, the stablecoin is overcollateralized and holders do not feel any jeopardy in current market conditions. 


Is UST different from all the other algorithmic stablecoins that have failed in the past? UST is special in the sense that it is strongly attached to Luna, Terra’s native token with the only purpose to stabilize the price of the protocol’s stablecoins aside from the functionalities of a governance token. The stability is coming from arbitrage trading by which UST is burned in exchange for Luna and vice versa. Let’s go through an example: If the demand for UST increases strongly at a given time, the price on exchanges will go up e.g. to 1.10 UST per US Dollar. This gives UST holders the opportunity to burn UST and receive Luna tokens worth 1.10 in Luna. The opposite can be done, if the price is at 0.90 UST per Dollar. Luna holders can get 1 UST for 0.90 Dollar in Luna. This has been working well for a long period of time except for this week and once before when the confidence of UST holders was vulnerable for a short period of time. In a bull market this model works perfectly fine as demand and confidence are high. The surge of Luna & UST from nowhere to the Top10 by market cap was an incredibly fast ride. 

The Death Spiral

When the ship starts sinking. As we described before, once UST falls below 1 US Dollar, Luna holders are able to redeem the Luna token for UST with a premium (premium = 1 Dollar - UST value). In a normal market environment, this will be the case as traders act rationally and want to maximize their return on investment. The holder trusts the algorithm and arbitrage traders in this case. However, crypto markets are inefficient and trust can be lost easily, if things go wrong. Some argue that a coordinated attack to spread fear led to the initial de-peg of UST, but this is still not confirmed. It is certain that UST experienced huge selling pressure caused by large liquidity removals from the Curve Finance pool. More and more people were selling their UST holdings in addition to liquidations across different platforms and Luna was inflating as Luna holders would receive more UST in exchange for Luna and also sell more Luna on secondary markets because of the strong sell-off. Relying completely on incentive structures instead of collateral is fatal once things are falling apart. A chain reaction led to a significant sell-off across the entire crypto market with most currencies declining at least 30% during the past days.

Key Learnings

What do we learn from it? A Web3 user needs to understand how a stablecoin ensures stability. Depending on the mechanisms, the carried risks by the stablecoin will be different. Once risks are identified, they can be effectively managed. In this case the risk could have been hedged by using an insurance provider such as Nexus Mutual or to open a short position with leverage once UST started to de-peg. In general, stable-coins should be diversified in a portfolio equally as other allocations. Early-warning systems can prevent losses becoming exorbitantly high, with immediate action on alerts. 

CoinRisk - a Risk Analysis Platform

With CoinRisk we provide a platform that helps you identify and mitigate risks around DAOs and tokens. We are able to identify several risks e.g. price volatility changing in an instant  or sell pressure increasing (may it be vested tokens are unlocked or other reasons) and therefore, being able to make assumptions on the arising risks. Aside from that, we provide a holistic risk analysis tool that can give you an impression on existing risks concerning the areas technology, tokenomics, finance and operations of DAOs. Feel free to register on our platform and to explore our risk analysis tools.