Do you remember the situation where LUNA and its stablecoin UST fell into a death spiral? It plummeted 99% overnight.

The collapse of LUNA and TerraUSD (UST) was a significant event in the cryptocurrency market in 2022, revealing potential flaws in the design of algorithmic stablecoins and the importance of market confidence for these systems. Here is an overview of the event:

The relationship between LUNA and UST

- LUNA is the native token of the Terra blockchain, used for paying transaction fees, participating in governance votes, etc.

- UST is an algorithmic stablecoin issued by Terra, aimed at maintaining a 1:1 value peg with the US dollar.

Mechanism of the death spiral

The design of UST relies on an arbitrage mechanism to maintain its price stability around 1 USD. When the price of UST is above 1 USD, users can burn LUNA worth 1 USD to mint new UST; conversely, if the price of UST is below 1 USD, UST can be burned in exchange for an equivalent amount of LUNA. This mechanism is theoretically supposed to help UST maintain its value, but in practice, several issues have been exposed:

1. Loss of market confidence

Once investors start to doubt whether UST can maintain its value, panic selling can lead to a decline in UST’s price, further undermining market confidence and triggering more selling behavior. Even the most stable stablecoin cannot withstand 90% of people selling off.

2. Liquidity crisis

As the price of UST declines, more and more people choose to exchange UST for LUNA and sell it, leading to a sudden increase in LUNA supply, which in turn lowers the price of LUNA. The sharp drop in LUNA's price made it no longer economically feasible to support UST by burning LUNA, exacerbating the decoupling of UST.

3. Intrinsic vulnerability of algorithmic stablecoins

Algorithmic stablecoins do not have physical assets in the traditional sense as support; instead, they operate based on market supply and demand and the trust among participants. Therefore, they are more susceptible to shocks under adverse market conditions or large-scale attacks.

4. Impact of external factors

Fluctuations in global financial markets, changes in macroeconomic conditions, and other external pressures can also affect the performance of algorithmic stablecoins like UST. For example, during the crash in 2022, the downward trend of the entire cryptocurrency market also played a role in exacerbating the situation.

Outcome

Ultimately, this crisis led to UST completely losing its peg to the US dollar, and the value of LUNA nearly dropped to zero. Moreover, this incident attracted broader attention, with several key figures, including U.S. Treasury Secretary Janet Yellen, expressing concerns about the risks of stablecoins.

Revelation

From the case of UST-LUNA, we can learn that although algorithmic stablecoins attempt to provide a decentralized and efficient solution, they still face many challenges in practice. Particularly for projects that heavily rely on market confidence and liquidity to maintain value stability, any factors that undermine these elements can lead to catastrophic consequences. Do not assume that stablecoins are necessarily stable.