A stable coin is a blockchain token with a “pegged value.” Rather than fluctuating like Bitcoin or Ether, a stable coin remains at the same price. Tether, USDC, and UST are all blockchain tokens with a pegged value at $1. Stable coins provide an onramp to the cryptocurrency industry, and provide a safety asset within the crypto ecosystem, where money can be held at a stable price if the price of major cryptocurrencies are falling.

Stable coins maintain their pegged value through algorithmic issuance of tokens. While the tokens trade based on traditional market supply and demand, the issuing body (Tether, Circle, Luna) adds or removes tokens to stabilize the price. When the crypto market has a red day, investors flock to stable coins to avoid further losses, waiting to jump back into their original investments once they have bottomed out. On these red days, demand for stable coins is hot, and the price might increase by a small amount. The issuing body would then issue additional tokens to stabilize the price.

Stable coins are not always pegged at $1. Several projects seek to back their tokens with decentralized blockchain assets, most commonly Bitcoin or Ether. On-chain collateral for their currency removes any speculation or doubt that the issuing body has full backing for their currency. This is important for investors, as falsified collateral reports have been published in the past. Tether, issuer of UST, the largest stable coin to date, was fined $41 million by the CFTC after it was discovered that they only had enough collateral to back their tokens about 25% of the time. On-chain collateral would be visible and transparent to any investor.

Terra was one of the first issuers to back their stable coin, UST, with on-chain digital assets, using their token Luna. It is important to note that Terra also had several billion dollars in Bitcoin collateral on the side. Their stable coin UST was pegged at $1, but in periods of demand for stable coins, the price might rise to $1.01. At this point, investors in Luna can convert their Luna for UST. This increases the supply of UST, which will help bring down the market price back to $1. The investor can then sell the UST at $1.01, making 1% on the transaction. The brilliance of the TerraUST/Luna conversion is that investors are incentivized with an arbitrage opportunity to regulate and maintain the stable coin’s price. In the Terra ecosystem, no issuing body increases or decreases the supply of UST; rather the market does so itself. Investors trust that this self-correcting cycle will hold up their stable coin.

On May 10th, the price of UST fell from $1 to $0.62, a shock to the cryptocurrency community. In the following days, it fell further to less than a cent. For the last six months, crypto lending platform Anchor offered a 20% yield to investors who bought UST and lent it on the Anchor protocol. This move was meant to be a marketing campaign by Terra, hoping to draw in new customers. Such a high return led to countless investors flocking to UST, hoping to be rewarded with such a high yield. This opened the door for a dramatic attack, being likened to George Soros’ attack on the Bank of England.

Terra held several billion dollars worth of Bitcoin in collateral for its UST stable coin. An attacker borrowed $3 billion in Bitcoin and bought about $1 billion in UST. The attacker then started selling the UST very quickly, destabilizing UST and dropping it below the $1 peg. Terra sold more and more Bitcoin as the price of UST dropped, hoping to restabilize the price. However, this caused the Bitcoin market to tank as well, with so many coins entering the market. The attacker then bought back their Bitcoin, essentially “short selling” Bitcoin for a huge profit. As a result of the attacker dumping $1 billion in UST on the open market, other market participants lost faith in the stable coin and their promised 20% yield, causing a massive bank-run on UST, with almost all holders attempting to sell. As a result, the attacking party made off with a huge gain on their short sale of Bitcoin. UST and Luna are now worth practically nothing, as investors lost faith in the tokens.

While on-chain collateral for stable coins was a widely anticipated development for the crypto community, the Terra attack shows two important lessons for investors. First, the attacker relied on the widespread panic and subsequent bank run on UST once its price was low enough that investors lost faith. Stable coins with larger market caps, and therefore larger liquidity pools, are harder to manipulate. While no stable coin issuer can simply increase their market cap at will, investors and issuers alike should see the benefits of more established projects, understanding that smaller cap projects are riskier investments, as they are prone to similar attacks. Second, the irresponsibility of Do Kwan, founder of Terra, is greatly responsible for the bank run that occurred on his token. Kwan, an energetic and eccentric entrepreneur, is also a shady businessman, who began his career with an algorithmic stable coin project named Basis Cash in 2020, which also failed to maintain its $1 peg. Kwan’s 20% yield Anchor marketing campaign was unsustainable from the start and was designed to be a Ponzi scheme. Kwan paid investors their 20% yield with money from new investors, taking advantage of investors for his own company’s gain. The unrealistic expectations of investors led to their exaggerated fear when the coin dropped, causing the bank run and crash of UST. Investors need to be wary of unrealistic returns and conduct research on the individuals they are trusting with their money.

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Why the Crypto Market Crashed: The Attack on…