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This month the TerraUSD stablecoin and associated Luna reserve cryptocurrency crashed and lost most of its value. About $45 billion in market capitalization vanished within a week.

Apparently there was some sort of sell-off, but then TerraUSD was supposed to be a stablecoin, being pegged to the US dollar via a complex algorithmic relationship. That algorithm must have failed.

How has it failed? How fragile was this pegging of a cryptocurrency to the USD?

I guess that different currencies can ultimately never be pegged perfectly and a stablecoin is a bit of a misnomer, but still I wonder how easy it might have been to break this pegging.

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It failed because the collateral of TerraUSD was Luna. Here's how it worked in very simplified terms:

If people wanted to divest from TerraUSD (sell), to keep the value of TerraUSD from collapsing the algorithm would buy TerraUSD (thus decreasing the amount of circulating coins) and putting the price back at being stable. Now for the algorithm to be able to buy, it needs some cash to do so. And that cash was collateralized by Luna. When Luna collapsed, TerraUSD had no way of keeping its peg to the USD.

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  • $\begingroup$ Thanks. But how could this have been guaranteeing a pegging to the USD if not Luna was by itself pegged to something connected to the USD? Or was Luna just a "normal" cryptocurrency? Was there any connection to the USD at all? If not, how could it have achieved the pegging with the USD? $\endgroup$
    – Trilarion
    May 25 at 19:46
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    $\begingroup$ Luna was some other crypto with some value. What was happening was that Luna was used to buy Terra when investors wanted to sell terra thus keeping it's priced pegged to 1 USD. Luna itself does not need to be pegged. Just to have enough value to redeem all Terra investors if needed. $\endgroup$
    – phdstudent
    May 25 at 19:48
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    $\begingroup$ Tied to Luna but pegged to USD, yes. $\endgroup$
    – phdstudent
    May 25 at 19:53
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    $\begingroup$ @Trilarion It was guaranteed algorithmically so long as the value that could be materialized by being able to create more Luna remained sufficient to handle the redemption demand on TerraUSD. There was a second (non-algorithmic) layer of peg defense too, but that failed also. $\endgroup$ May 26 at 6:40
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    $\begingroup$ So it was in a way a badly wrong way risk, the value of the collateral held (LUNA) happened to be highly positively 'correlated' to the TerraUSD (= negative correlation to counterparty credit, where cp is Terra). $\endgroup$ May 26 at 9:30
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How has it failed? How fragile was this pegging of a cryptocurrency to the USD?

I guess that different currencies can ultimately never be pegged perfectly and a stablecoin is a bit of a misnomer, but still I wonder how easy it might have been to break this pegging.

It depends on the quality of the collateral, like in all banking

  • How much there is collateral

  • How liquid is the collateral

  • How much there is withdrawal buffer

Every time someone is withdrawing, the buffer goes down and collateral must be liquidated to refill the withdrawal buffer. If there is not enough collateral, then a bank run / death spiral may ensure.

Terra UST was 90% having no collateral and then redemption via Luna burning (might be seen as collateral)? UST had grown too big and too fast because of "guaranteed" 20% APY on Anchor lending.

When Luna market value dipped, there was not enough Luna left in the world to redeem all UST. That's when the run on the bank happened, causing a death spiral.

What comes to other stablecoins, here is a good image from SebVentures:

enter image description here

More about the history and features of algorithmic stablecoins in my Twitter thread.

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    $\begingroup$ I have a hard time visualizing how the concept of Luna equates to the concept of negative equity. Can you explain? Or is it just that Luna is fundamentally broken/worthless and therefore doesn't appear on the chart at all? $\endgroup$
    – user253751
    May 27 at 11:00
  • $\begingroup$ It's a good question. I think the negative equity comes only play after the value of Luna has fallen so much that UST cannot be redeemed back to Luna "worth of a good price". If UST market cap > Luna market cap, it is realistic to say that it is not possible to redeem UST any more without a death spiral. However because UST can been always redeemed Luna (sans the Terra chain being halted) it is technically not so - you can keep printing more Luna tokens and try to sell them as long as Luna goes so low that you hit rounding errors and division by zero error. $\endgroup$ May 27 at 12:52
  • $\begingroup$ And this is what happens with the death spiral - as long as LUNA trades on any crypto exchange people try to exit their UST positions by redeeming it to Luna and then selling this Luna faster than Luna value keeps falling - to coup some losses. $\endgroup$ May 27 at 12:54

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