Over the last several days, defi has been hit hard. And no one has been hit harder than the Terra Luna ecosystem.

UST, a completely algorithmic stablecoin, has lost its peg. At the time of this writing, it’s under $.35. This is terrible news for an asset that’s supposed to hold a dollar at all times.

Luna, the better half of UST, has tanked. What was once the darling of defi, Luna, has gone from ATHs a month ago to under a penny at the time of this writing. Essentially, it’s dead.

How did this disaster happen? Let’s dive in.

How do UST and Luna Work?

UST is a completely algorithmic stablecoin. There is no backing to it, at least not in the form of USD. Instead, it works on a mint and burn system. UST is minted by burning Luna, and it is redeemed by minting Luna.

The meteoric rise of Terraform Labs and its blockchain partially came from its owner and number one hype man, Do Kwon. His marketing is top-notch, with tweets like this one, showing how fearless and confident he is in his product:

Note: This tweet did not age well...

As an idea, UST and Luna are great. It was an attempt at making a truly decentralized stablecoin product that offered high-yields and wealth-building opportunities all on a single chain. So what went wrong?

Why did UST Crash?

What Goes Up…

The problem with any kind of algo-stablecoin doesn’t show itself while the market is pumping. As long as Do Kwon was a marketing genius and influencers all over Twitter and YouTube were shilling his product, very few people complained. Why would they? Early investors made a ton of money.

However, when things go wrong, there isn’t an algorithm that can save these products from a bank run. And that’s exactly what happened.

No one investor could topple this behemoth. At one point, it rose to the third spot on stablecoins by market cap, behind USDT and USDC. It took something much more powerful.

…Must Come Down

There is some speculation, and even some evidence, that the collapse of this ecosystem is due to direct involvement from Wall Street giants. You’re more than welcome to check this out and make up your own mind until we get more concrete information

TLDR: Wall Street big boys borrow over $3 billion worth of Bitcoin, bought a ton of UST in an OTC deal, caused a bank run on UST when they pulled out, made a ton of money on their short, and bought more Bitcoin for cheap.

Three birds. One stone. Maybe four? I don’t think anyone is counting anymore.

They made a ton of money while destroying a threat and discrediting its founder.

/conspiracy theory talk

Let’s move on.

The Different Types of Stablecoins

Just because a stablecoin is worth $1, or 1 of any other kind of fiat, does not mean they’re all the same or created equally. Most, if not all, can be put into three categories:

  • Overcollateralized
  • Collateralized
  • Algorithmic/partially-algorithmic

Let’s break down how they’re different and the functions of each.

Overcollateralized Stables

Overcollateralized stablecoins require more collateral to mint than the value they are minted for. DAI is one of the safest and best versions of this type of stablecoin.

To mint DAI, you’ll need between 130%-150% collateral in the form of ETH or other volatile, decentralized assets. At least that’s how it used to be. DAI now has quite a bit of USDC in its treasury as part of a fail-safe measure. DAI is now backed by more than 50% USDC.

Having so much USDC lowers decentralization but increases the stability of the stablecoin’s peg. While this is unfortunate, considering many investors get into crypto to escape tradfi and regulation, the DAO that runs DAI’s parent company decided it was needed.

If this ruffles your feathers a bit, there are other overcollateralized stablecoin options. They are usually smaller and confined to one or possibly a few blockchains. MAI is one example.

Collateralized Stables

These are usually the first stablecoins that new investors come into contact with in crypto. Examples are USDC, GUSD, and BUSD. If there is a centralized exchange, they likely have their own fiat-backed stablecoin to offer customers who want to pull money from the blockchain to their personal bank accounts.

Stablecoins that are fiat-backed always have exact cash or cash equivalents on hand so that they can exchange one for one at any given time. The one exception is USDT, aka Tether, which claims to have cash on hand but has never allowed a third party to audit them.

For this reason, most exchanges, centralized or decentralized, view Tether as a riskier asset than other stables. While this may give you a little extra interest on the supply side, it may be a hassle on the borrowing side.

Remember guys. This is crypto. Anything can happen. You can make yourself as safe as possible and there is a chance you still won’t be safe. It’s the risk we take for financial freedom.

Algo-Stables

Just like UST, all algo-stables are relatively risky investments. Unlike UST, many of them, especially the most popular, are only partially algorithmic. This means they’re also partially collateralized by fiat concurrency. The owners of the project, or the DAO in some cases, decide how much the governance token should back the stablecoin.

One of the most popular is Frax. Roughly 80% of Frax is back by fiat currency. The remainder is backed by FXS, the governance token behind the project.

FXS uses a ve (curve) locking model. To receive the maximum amount of rewards, investors are required to lock up tokens for a maximum locking period, which actually helps Frax maintain its peg and increase the value of FXS over time.

If you take away the ability to sell, there is less selling pressure on a token. FXS’s price is market-driven. With little selling pressure, it takes less buying pressure to increase the market value.

At the time of this writing, Frax is doing a pretty good job of maintaining its peg despite all of the market turmoil. FXS is more susceptible to all of this volatility and has taken a hit, just like everything else.

The Takeaway

I don’t care how safe you think a stablecoin is. As long as crypto is crypto, there is a risk your tokens will go to zero, even if that scenario is unlikely.

However, I also think now is the time to start loading your bags to prepare for the next bull run. How you do that is up to you, and the moves you make should always align with your strategy. This includes stablecoins.

They’re an essential part of crypto investing, but you should never 100% rely on them as a safe place to store your cash.

Disclaimer: This article is not financial advice. This is the opinion of the author, who is not a financial services professional. Do your own research and consult a professional investment advisor before making any investment decisions.
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