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 reserve of assets that back the stablecoin. The thinking goes that, for every stablecoin distributed, there should be one dollar in the reserve. Depending on what asset the stablecoin is pegged to, this 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 reserve 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 UST Works
UST is the stablecoin on the Terra blockchain. It attempts to hold its value to one U.S. dollar through a process known as arbitrage. Rather than keeping a reserve of money, UST uses LUNA, the native cryptocurrency of the Terra blockchain to maintain its one-dollar price.
UST and LUNA are constantly trying to achieve balance. The algorithms built into the smart contracts essentially track supply and demand of UST and LUNA.
If the price of UST begins to rise above one dollar due to more people buying UST, then holders of LUNA are able to sell their LUNA (for a profit) back to the blockchain. The algorithm then converts this LUNA into UST. As more UST is added to the system, the price of UST decreases back to one dollar. Contrarily, if UST decreases in price, holders of UST are offered to convert their UST into LUNA coins to decrease the supply and thus increase the value of UST.
The dynamic between UST and LUNA is most important. If no one wants to exchange their LUNA or UST when prices are out of balance then the stability of UST is at risk. Without UST being worth one dollar then the LUNA coin becomes less attractive to hold as well.
The Rubber Meets the Road
This exact scenario played out in early May 2022. On May 9, 2022, UST's price plummeted to as low as $0.68. The decrease came as the result of a broader market sell-off in all cryptocurrencies. Investors didn't want LUNA or UST. LUNA dropped by as much as 60% in just a matter of days. This decoupling compromised the algorithm and sent both cryptocurrencies into a nose-dive.
Developers of the Terra blockchain were aware that a situation like this could happen. Coincidentally, the non-profit organization behind Terra's blockchain, the Luna Foundation Guard, announced that it would start buying Bitcoin in just the last couple months. The idea was that if UST lost its peg, the reserve of Bitcoin could be used as arbitrage like LUNA normally would.
With UST losing its peg, the time came for the Bitcoin reserve to be released. Shortly after UST fell to new lows, the reserve was dispersed to serve as a shock absorber. It may have worked, but the jury is still out. UST's price rebounded---just not quite to the coveted one-dollar mark.
The longevity of UST will depend on how the stablecoin rebounds. The longer it takes to reach one dollar the more likely it will 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 remain resilient in a turbulent market.