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How a crypto bank run in Terra’s UST could rock cryptocurrencies

Following a massive shedding of cryptocurrencies and other risky assets by investors, the stablecoin TerraUSD (UST) “de-pegged” from its essential $1 value this week, while its sister token Luna dropped 79% from $82 to $17.2 over five days.

In a fight to save both cryptocurrencies, the Luna Foundation Guard (LFG), a nonprofit supporting the Terra blockchain, has deployed $1.5 billion in bitcoin and UST loans.

Whether the stablecoin fully recovers or collapses, the ongoing battle could have a lasting impact on the crypto market.

“Besides the obvious, real money and people’s livelihoods are at stake, these types of crypto monetary experiments are important for the evolution of the space,” John Kramer, head of over-the-counter and DeFi trading with GSR, told Yahoo Finance. “Whether UST ultimately recovers or collapses, it motivates others to build more robust stablecoin alternatives.”

What happened?

On Saturday, the LFG began removing approximately $150 million in UST from the decentralized exchange Curve. The move unintentionally sparked a multi-million dollar sale of the stablecoin, according to public comments from Do Kwon, the 30-year old co-founder and creator of Terraform Labs and member of the LFG.

Minutes after LFG removed its funds, an unknown address sold $84 million in UST on crypto exchange Binance. Demand for UST became “off balance” on Curve, according to Lily Francus, a director of quantitative trading strategy with Moody’s, spurring more holders to sell for better-yielding stablecoins.

By midday Monday, UST’s value had fallen 5% to 95 cents per coin — not bad relative to bitcoin which lost 11% — but far more significant given how past stablecoins have plunged towards collapse in similar “de-pegging” events, Francus told Yahoo Finance.

By Monday evening, UST had plummeted 30% from 99 cents to 69 cents. Its sister token, Luna — a crypto once among the top 10 by market capitalization — fell from $60 to $25. It has since tumbled to $17 per unit, but that’s still a 55% drop over the past 24 hours.

Ryan Clemens, an assistant professor of Business Law and regulation at the University of Calgary, isn’t surprised by the turn of events.

“Algorithmic stablecoins are based on confidence and trust in the economic incentives of the stablecoin issuer's underlying ecosystem. Once that trust and investor demand evaporates, they quickly fail in a death spiral,” Clemens wrote in an email to Yahoo Finance. “And we saw that.”

How stable is UST stablecoin?

3D rendered image of blockchain technology (digital cryptocurrency) token /coin levitating on shiny gold and black pedestal, black tiled floor and black background with copy space.  Concept of blockchain, decentralized financial system. High angle view. 3D rendered image.
(Photo: Getty Creative)

Unlike cryptocurrencies — which are known to fluctuate widely — the point of stablecoins is to provide price stability for commercial payments and a safe haven from volatility for investors.

Stablecoins peg their value to another asset, most often the U.S. dollar, with the aim of wavering as little as possible from that asset’s value.

While the largest stablecoin projects — such as Tether (USDT) and Circle’s USD Coin (USDC) — are backed by assets and have faced regulator scrutiny on the quality of their reserves, UST’s approach is far more radical. It’s an algorithmic stablecoin, which primarily uses market mechanics to manage the asset peg by linking UST with its sister coin, Luna.

“In theory, these mechanics ensure traders can always swap $1 worth of UST for $1 worth of Luna, which has a floating price,” said Walter Teng, a Defi strategist with research firm, Fundstrat.

Waning UST health

A big part of UST’s appeal is it also offers a 19.5% annual percentage yield (APY) on Anchor, a lending and borrowing protocol on the Terra blockchain, returns that are magnitudes what traditional bank accounts and most other stablecoins provide. As a result, Anchor holds 56% of UST’s total $17.5 billion circulating supply.

That means Anchor's health serves as a proxy for UST’s health, according to Teng.

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But Anchor can’t afford the interest it pays out to borrowers and instead relies on its “yield reserves,” Teng said. And if nothing changes this month, Anchor has less than 50 days before it runs out of funds, according to a model Teng shared with Yahoo Finance, which doesn’t account for any funds from UST’s external backers.

Since February, LFG has been preparing for such a scenario by buying Bitcoin and Avalanche tokens (AVAX), so it can step in as a buyer of last resort to defend its $1 peg by selling reserves. As of last week, LFG held 80,394 bitcoins, roughly $3 billion at the time of its acquisition announcement.

As of Monday afternoon, LFG had taken out a $150 million credit loan, and Kwon announced that LFG agreed to issue a $1.5 billion loan denominated in bitcoin and UST.

Ripple effects

The fight for UST to retain its $1 peg could have significantly negative ramifications for other parts of the crypto market — especially bitcoin.

“It all depends on how aggressively they need to defend the peg,” Bennet Tomlin, a data scientist and financial investigator, told Yahoo Finance.

“Any protocol that involved UST as collateral could see liquidations, any swaps trading that depended on UST could be somewhat impaired,” Tomlin added. “Loss of confidence in UST could cause loss of confidence in other algorithmic stablecoins.”

After reports surfaced Monday that major crypto exchange Binance was not allowing trading of UST to customers unless transacted below a 70-cent, per-unit price limit, the exchange announced it had temporarily suspended withdrawals of UST and Luna due to “network slowness and congestion.”

As of Tuesday afternoon, Anchor had added Solana (SOL) as an asset traders could borrow against. Kwon said over Twitter his team is “close to announcing a recovery plan.”

"Hang tight," Kwon added.

While UST’s fate continues to develop, the parties likely to pay the most will be backers hoping to save UST and probably, retail investors, according to Moody’s Francus.

“Like always,” she added.

Tomlin is less concerned about the venture capitalist firms.

“The cost basis for venture capitalists who invested in Luna is well under a dollar. They can weather nearly any drop,” he said. “The real risk is for retail investors and others who joined later, especially near the peak value for Luna of over $110.”

David Hollerith covers cryptocurrency for Yahoo Finance. Follow him @dshollers.

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