UST on Terra: Lessons Learned and Best Practices for Stable Asset Design
The UST collapse last year was devastating for so many of us in the DeFi space. In this article, we’ll take a look at the lessons to be learned from UST and best practices for stable asset design going forward.
The Token Architecture of UST
UST was designed to maintain its value by algorithmically adjusting the supply of UST’s sister coin LUNA.
The algorithmic approach meant that there were no reserves backing the stablecoin. The UST/LUNA supply was adjusted through a combination of incentives and penalties for traders and arbitrageurs, which tried to ensure that the market supply of UST remains in balance with LUNA.
Unfortunately, when enough people caught on that this wasn’t a sustainable way to keep a peg, massive amounts of people began withdrawing their money which caused UST to utterly collapse.
Lessons Learned from UST
The failure of UST on Terra provides valuable lessons for the DeFi industry. Here are some of the lessons learned:
- Algorithmic design can never provide stability: UST has proven that an algorithmic approach that doesn’t relying on collateralized reserves will never work.
- DeFi is still in it’s early stages: The collapse of UST doesn’t mean that all crypto is doomed for failure, rather it means that we’re still in the early stages of decentralized finance. If you don’t do comprehensive research and risk-management then you can always get burned. The collapse of UST doesn’t imply that all stablecoins are doomed to failure. UST showed us that some cryptocurrencies have been poorly designed, while others have much higher quality designs. A good rule of thumb is to track the projects that have survived multiple bear markets.
- Don’t rely on centralized exchanges (CEXs): After the UST collapse happened, multiple CEXs suspended withdrawals of UST leaving retail investors that held UST holding even larger bags than they needed to. Holding crypto on your own wallet is always safer than trusting a third-party with your assets.
- Competitive Yield Attracts Adoption: Although we’ve talked about all the negative things that UST did which led to it’s downfall, we can also learn from UST’s ability to grow so fast and reach such large adoption. UST understood that yield attracts users, even though there yield was inflated and unsustainable. In a positive light, architecting a stable asset to generate sustainable, real yield will likely lead to more adoption and appeal.
Best Practices for Stable Asset Design
Based on the lessons learned from UST on Terra, here are some best practices for stable asset design:
- Always Over-collateralize: Stable asset designers should never consider an algorithmic approach to provide stability without relying on collateralized or fiat reserves. This is the #1 rule to be learned from UST.
- Native Yield is Best: If you don’t know where the yield is coming from, then you’re probably the yield for other people. If a stable asset project has high yield, research it and figure out where it’s coming from. Yield that is native to the protocol (like Davos Protocol) will be much more reliable than yield that is generated external to the protocol. For example, if a protocol takes the reserves and then implements some yield farming strategy on a separate DEX, then this will be much more risky.
- Transparency is key: The more transparency the better. It’s much better to be able to track the total value of the reserve and compare that to the total market cap of the stable asset in circulation, all on-chain. If you aren’t sure the value of the collateralized assets that are locked in the smart contract then it’s harder to be confident that the peg is reliable.
- Audits help: To gain trust from users, stablecoin designers should ensure transparency by making their code open source and regularly auditing their reserves through professional auditing services.
Conclusion
In conclusion, the collapse of UST on Terra serves as a valuable lesson for the DeFi industry. The algorithmic approach of UST showed us that stable asset designers should never consider an algorithmic approach to provide stability without relying on collateralized or fiat reserves.
Furthermore, the collapse of UST does not imply that all stablecoins are doomed to failure; rather, it emphasizes the need for comprehensive research and risk management. Additionally, it highlights the importance of transparency, audits, and not relying on centralized exchanges. By adhering to these best practices, stable asset designers can provide reliable and trustworthy stable assets for the DeFi community. As the DeFi industry continues to evolve, it is crucial to learn from past mistakes and build a more secure and sustainable financial ecosystem.
