The world’s largest algorithmic stablecoin is in the spotlight for all the wrong reasons. TerraUSD (UST) was designed to track the value of the US dollar, but its value suddenly dropped in May 2022. What happened?
Two types of stablecoins
Collateralized stablecoins have a pool of assets that back the stablecoin. The idea is that for every stablecoin distributed, there should be a dollar in reserve. Depending on the asset the stablecoin is pegged to, it can be gold, euros, dollars, or even real estate. Stablecoins like Tether and USDC are examples of collateralized stablecoins.
Algorithmic stablecoins are a newer type of stablecoin. Instead of using a pool of assets, algorithmic stablecoins use smart contracts to maintain their “peg” to the dollar. One of the best examples of an algorithmic stablecoin is TerraUSD (UST).
How the UST works
UST is the stablecoin on the Terra blockchain. It attempts to maintain its value in one US dollar through a process known as arbitrage. Instead of keeping a reserve of money, UST uses LUNA, the native cryptocurrency of the Terra blockchain to maintain its price of one dollar.
UST and LUNA are constantly trying to strike a balance. Algorithms built into the smart contracts essentially track the supply and demand for UST and LUNA.
If the price of UST starts to rise above a dollar due to more people buying UST, then LUNA holders can sell their LUNA (for profit) back to the blockchain. Then the algorithm converts this LUNA to UST. As more UST is added to the system, the price of UST decreases back to one dollar. On the contrary, if the price of UST decreases, UST holders are offered to convert their UST into LUNA coins to decrease supply and thus increase the value of UST.
The dynamic between UST and LUNA is more important. If no one wants to trade their LUNA or UST when prices are out of balance, then the stability of UST is at risk. Without UST being worth a dollar, the LUNA coin also becomes less attractive to hold.
The rubber meets the road
This exact scenario played out in early May 2022. On May 9, 2022, the price of UST crashed to $0.68. The decline came as a result of a broader market sell-off across cryptocurrencies. Investors did not want LUNA or UST. LUNA fell by as much as 60% in a matter of days. This decoupling compromised the algorithm and sent both cryptocurrencies into a tailspin.
The developers of the Terra blockchain knew that a situation like this could happen. Coincidentally, the non-profit organization behind the Terra blockchain, Luna Foundation Guard, announced that it would start buying Bitcoin in the last two months. The idea was that if UST lost its peg, the Bitcoin reserve could be used for arbitrage as LUNA normally would.
With UST losing its peg, it was time to release the Bitcoin reserve. Shortly after UST fell to new lows, the stock was dispersed to serve as a buffer. It may have worked, but the jury is still out. The price of UST recovered, but not quite to the coveted one-dollar mark.
The longevity of UST will depend on how the stablecoin rebounds. The longer it takes to get to a dollar, the more likely it is to lose credibility. Algorithmic stablecoins are one of the most innovative concepts in the cryptocurrency market. But now they are being put to the test. Only time will tell if they have what it takes to stay resilient in a turbulent market.