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June 1, 2022

Post-Mortem of the UST Collapse: The Future of Crypto as an Asset Class

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It's being called "the Lehman Brothers incident of the cryptocurrency industry".

The fourth largest cryptocurrency by market cap, UST, recently de-pegged from $1. This led to a complete collapse of its ecosystem (Terra-Luna), wiping out roughly $45 billion in market capitalization and leaving investors with massive losses.

Why did this all happen? How does it change the crypto ecosystem? And what implications does it have for other digital assets like bitcoin and Ethereum?

On UST, Terra-Luna, and algorithmic stablecoins

In 2018, Do Kwon co-founded Terraform Labs, which aimed to build a blockchain centered around an algorithmic stablecoin, called TerraUSD to power decentralized finance (DeFi) applications.

Stablecoins are intended to maintain value and avoid volatility. Most stablecoins on the market are custodial – they are collateralized by fiat or high-quality debt instrument reserves.

Algorithmic stablecoins differ. Their value is stabilized by a paired asset that absorbs volatility, via an algorithm that maintains price equilibrium.

UST was tied to Terra's governance token LUNA. UST and LUNA co-existed through a burn/mint function designed to keep the value of UST pegged to $1. 

  1. If demand for UST pushed its price above $1, users could burn $1 of LUNA to mint UST, increasing its supply and thus putting downward pressure on its price until the $1 peg was restored.
  2. If UST's price fell below $1, users could burn it for $1 of LUNA. Therefore, UST was essentially backed by the demand for LUNA, which was used to absorb volatility in UST. 

The collapse

The weekend of May 7 saw major outflows of UST from Anchor, a DeFi lending protocol that offered a 20% annual yield on UST deposits. Combined with short positions on Bitcoin and LUNA and general crypto market bearish sentiment, UST began to de-peg, hitting $0.98.

A negative feedback loop ensued, causing more investors to withdraw their UST from Anchor in a bank-run scenario. TerraLabs added liquidity to the UST pool to defend the peg but was unsuccessful.

The inability to restore the $1 UST peg caused further panic. Downward pressure continued which caused UST to de-peg further and significantly reducing the price of LUNA. Weakness in the broader crypto and equity markets further accelerated the decline.

Eventually, UST hit $0.19 while LUNA lost over 99% of its value. Billions of UST/LUNA were burned and minted as the algorithm tried to restore the peg, which ultimately failed. When the dust settled, over $45 billion of market capitalization had been wiped out. 

The downstream impacts

Calls for increased scrutiny of stablecoins soon emerged, with U.S. Treasury Secretary Janet Yellen pushing for regulation at the Senate Banking Committee, stating: "Digital assets may present risks to the financial system, and increased and coordinated regulatory attention is necessary.”

Yellen said that it would be "highly appropriate” for stablecoin regulation to table by the end of 2022 due to the “many risks associated with cryptocurrencies" and highlighted the need for a "consistent federal framework."

Other cryptocurrencies fell intra-day as investor sentiment turned bearish and a risk-off attitude ensued. The sell-off caused liquidations in leveraged positions, with both bitcoin and Ethereum plunging under key support levels.

Cryptocurrency brokerages like Coinbase and Binance experienced increased withdrawals, and in the case of the latter, significant losses from its own UST holdings. Other stablecoins like Tether came under fire for a perceived lack of transparency with regards to reserves. 

The outlook for crypto

Despite the collapse, the long-term outlook for the rest of the cryptocurrency market remain positive. The two largest cryptocurrencies by market capitalization, bitcoin and Ethereum possess significantly different mechanisms that preclude this type of collapse from occurring, despite fears of contagion.

Neither bitcoin nor Ethereum are stablecoins. Bitcoin is more akin to digital gold and a store of value, while Ethereum is a web3 platform with smart contract functionality. Their value is volatile and fluctuates based on supply and demand. Bitcoin has a fixed supply of 21,000,000 coins. Ethereum has no supply cap, but continuously takes tokens out of circulation, a process called "burning" that occurs with each transaction on its network. Both are considered decentralized and deflationary. 

Investors bullish on bitcoin and Ethereum and who seek a regulated, accessible, transparent, and professionally managed way of investing in cryptocurrency can look no further than to our suite of cryptocurrency exchange-traded funds (ETFs).

About the Author

Galaxy Digital

Galaxy Digital Capital Management LP is a diversified investment management company with a team of long-tenured institutional experienced professionals managing third-party capital across traditional and alternative asset classes, with strong relationships and connectivity in the digital asset, cryptocurrency and blockchain technology sector.


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