The Real Reason Why UST and LUNA are a Failure

By 2sats | 2sats | 12 May 2022

*obligatory not financial advice*


This has been an awful week for the cryptocurrency world. UST, one of the most trusted and largest US dollar stablecoins has completely failed at keeping its supposed value. Many people that want to use DeFi but are afraid of the high volatile of most of cryptos hold stablecoins instead, only to now lose 60+% of their funds anyway. This is a true disaster because not only will this scare countless of people and institutions away but many other blockchains and their DeFi applications were utilizing UST and now the damage is rippling across their entire market. Everyone has been waiting for Tether to eventually fail, but UST took everyone by surprise.

But why did this happen? Many people believe that a few investment funds and centralized exchanges worked together to get loans in UST only to then make its price tank so it’s easier to pay them back, basically shorting it. Not like anyone bothers to offer any evidence or reasoning for that accusation. But the reality is lot more boring than that, which is that there was always a fundamental flaw in the way UST was supposed to keep its peg.




How do LUNA and UST work?

They clearly don't.

But UST used to keep its value due to always being able to be traded for $1 worth of LUNA directly on the Terra blockchain. It was not backed by any specific amount of LUNA, but by however much LUNA currently had a value of $1. Terras other stablecoins work the same way.

This means that if the value of UST falls below $1 on any exchange, then you could buy it there for cheap and then burn it for $1 worth of LUNA to get an instant profit. Should it be traded above $1 on any exchange, then you could burn $1 worth of LUNA to get 1 UST and sell it on the exchange for a profit. Such arbitrage trading would regulate the supply of the stablecoin and keep the value close to 1 dollar with only small ups and downs.

This is different from most alternative stablecoins because they either depend on a centralized entity that backs their value with real life dollars, or on platforms like Maker DAO that let their users take loans by minting stablecoins if they leave a collateral with more value. Neither alternative is ideal because depending on any centralized middle men destroys the entire point of DeFi and taking loans with crypto as collateral can be very risky especially during bearish times like this.

UST offered a stablecoin that is decentralized and didn't need to be backed by risky loans. This has brought it a lot of popularity and thanks to Terras interoperability it has been adopted by most major dApps and blockchains. I myself thought that UST is best thing to happen to DeFi since the creation of Uniswap and it took me way too long to realize that this algorithmic approach doesn't take in account how volatile a cryptocurrency, like LUNA, can be.


What is the problem?

You don't receive 1 US dollar for burning 1 UST, you receive $1 worth of LUNA. This is a problem because should UST break its peg for a while, you could only get its true value by getting LUNA first and selling it. But if LUNA is being sold it loses value and if too many people sell it at once it could lose its value drastically and if people then burn their UST for $1 of LUNA it could happen that it loses its value by the time it is being sold. In practice this makes UST under collateralized when a lot of money is leaving the Terra blockchain.

I am not saying it’s impossible that the market was manipulated, but it didn’t require a manipulation to make UST collapse. It could be that someone was shorting UST and tried to supress its value for a while, but the holders of UST not being able to cash out without eating each other alive is a fundamental flaw that made the stablecoin a ticking time bomb.



What will happen now?

The entire crypto market will now take a massive hit because UST was so wide spread. It will also scare many people away from cryptocurrencies since now even stablecoins are apparently volatile like crazy. The market has been bleeding since the beginning of 2022 like the stock market due for various factors, like increased interest rates, and this will certainly make it worse.

There are also other cryptocurrencies that adopted the LUNA and UST dynamic and made their own stablecoins. Tron has launched its USDD stablecoin just one week ago and was celebrated for it, now it’s unlikely that USDD will be adopted by many people anytime soon. The Celo blockchain also has similar stablecoins for both the US dollar and the Euro, this stablecoins are algorithmic but are also backed by an on-chain treasury, so they should be safer than UST but there will likely not be many people that have a lot faith in them now. It would make sense that this cryptocurrencies would take a bigger hit.

Maker DAO and similar protocols could in the long run profit from this because DAI is now the most popular decentralized stablecoin. But this will likely take a while because stablecoins as a whole are not going to be in demand right now.

I think it’s safe to say that we are now in a bear market. Lucky enough, bear markets lasted on average 15-18 months since WW2 and the next Bitcoin halving is set in 2024, so just in time to make the crypto market bullish when the economy should start to recover. But we will likely not see many good news for cryptocurrencies until then. Now you need to be more careful with what you invest in and need to invest long term, if at all.




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