UST Death Spiral Recap

One of the largest market concerns at the moment revolves around the price parity of TerraUSD (UST), the largest algorithmic stablecoin by market capitalization and primary stablecoin of Terra. For the uninitiated, UST is meant to keep peg through an on-chain redemption mechanism where, at any point in time, a user can mint 1 UST by burning $1 of LUNA, and vice versa. This mechanism creates an incentive for arbitrage whenever UST drifts from a dollar. If UST goes above peg a user can buy $1 worth of LUNA, burn it for 1 UST and profit the difference. And if UST goes below peg a user can buy UST, burn it for $1 of LUNA and sell it for a profit. While seemingly simple on the surface, this breeds reflexivity that can be very painful in scenarios of extreme volatility.

The primary risk to algorithmic stablecoins is what is referred to as a “death spiral”:

Source: Twitter @ZeMariaMacedo

This either starts with (1) LUNA’s price falling enough so that holders of UST fear that their stablecoin isn’t solvent, or (2) there is a mass exodus from UST from a decrease in demand.

Once either of these conditions is met, the result is a continuous cycle in which UST falls below peg, newly issued LUNA is needed for redemptions, and LUNA is sold on the market, which causes an even further loss of faith in UST. Given a fall in LUNA’s value relative to UST’s, each cycle has a greater impact on the dilution of LUNA’s supply, and makes negative price impacts even more drastic.

This is very similar to the death spiral in scenarios of convertible bonds, where companies raise money by issuing debt that can be redeemed for shares. If the company is able to increase revenues and drive up the price of their shares, it means they end up with less dilution of shares for their capital. However, if the price of the shares fall, this leads to a death spiral where redemptions cause massive dilutions of supply, which either causes a massive dump in stock prices or single entities with very large control of the company.