TerraUSD's fall has triggered panic in an already volatile market
In a bear market, it feels like the world is crumbling. The sell pressure can make you feel like you are staring into the abyss; even algorithmic stablecoins are losing investor confidence.
To put things into context: TerraUSD (UST), an algorithmic stablecoin, was previously the third largest stablecoin by market capitalization, trailing only USD Coin (USDC) and Tether (USDT). It was also been considered among the most valuable cryptocurrencies in terms of market capitalization.
However, the recent crypto collapse has shown that algorithmic stable coins, amid the rising market uncertainty and volatility, are also prone to price fluctuations. Based on insights from Bloomberg, let’s take a closer look at the factors driving this instability and if crypto investors have cause for worry.
How stable are algorithmic stable coins?
The TerraUSD coin, or UST, an algorithmic stablecoin, fell to roughly 99 cents over the weekend instead of trading at $1, as it was intended. It had dropped to 60 cents on Monday evening in New York, smashing through its previous low of 92 cents set in May 2021. On Tuesday, it recovered some of its losses and is now trading between 90 cents and $1, indicating that it is in peril.
The cause of Terra’s coin being untethered has become a hot topic on the crypto scene. The mismatch occurred in the context of a strong selloff in crypto assets, including a drop in Bitcoin below $30,000, and a larger retreat from risk assets such as stocks. Whatever the trigger, it’s no small matter: According to CoinMarketCap, there are roughly 18.5 billion UST in circulation, a large enough number that its fluctuations could have systemic consequences for other coins and protocols. And Do Kwon, the UST founder, has already stated that he will acquire up to $10 billion worth of Bitcoin as part of his backing for the coin, further tying the initiative to the digital-asset market’s heart.
Conventional stablecoin issuers like Tether’s USDT and Circle’s USDC claim that their tokens are backed 1:1 by “real” assets like cash or highly rated bonds. These coins maintain their value because they may be easily exchanged for cash or highly liquid currency substitutes, according to theory. Algorithmic stablecoins, on the other hand, try to maintain their value by a combination of software instructions and active treasury management. The most popular and controversial of these tokens is UST, which works in tandem with a related token, Luna.
An investor who refused to be named stated that he used algorithmic stablecoins for arbitrage but has stopped because he does not perceive them to be stable or secure anymore.
Understanding how Terra works
UST is called algorithmic because it is backed by an on-chain algorithm that allows for supply and demand changes between them (the stablecoin) and another cryptocurrency that keeps them afloat. A smart contract regulates the relationship between the cryptocurrency and stablecoin enabling the algorithmic stablecoin to be stable.
In case of UST, the algorithmic tango is performed by UST, a stablecoin, and terra (LUNA), Terra’s native cryptocurrency that backs the stablecoin, on the Terra blockchain, which operates the largest algorithmic stablecoin network.
If the price of Terra’s stablecoin falls below $1, traders are encouraged to swap UST units for Luna, removing the former from circulation. Software programmes are also prompted to do the same thing. If the price rises above $1, the system reverses, removing Luna tokens from circulation and replacing them with fresh UST units.
Traders looking to profit from arbitrage possibilities frequently exchange UST for Luna and vice versa, ensuring that the price remains at or near $1. The crypto counterpart of above-market interest rates given by Anchor Protocol, a “decentralised lender” built on Terra’s blockchain, also contributed to UST’s price stability.
However, with the recent crypto crash, the mechanisms that lend UST stability became awry. Consequently, the dollar peg was lost and the value of Luna also slipped. Ergo, a domino effect was sparked. Ergo, Kwon and the so-called council of the Luna Foundation Guard (LFG), a group of crypto players that includes Kanav Kariya of Jump Crypto, were required to make a series of crypto market interventions. According to CoinMarketCap, Luna was selling at roughly $29, down 52 percent from the day before.
This is not the first time that an algorithmic stablecoin has failed: In 2021, the FEI stablecoin experiment has failed to maintain a USD peg, with $1.2 billion ETH trapped in the smart contract.
In a 2021 Tweet, well-known investor Mark Cuban said, “What is an algorithmic stablecoin? Is it stable? Do buyers understand what the risks are? It needs standards.”
Investors should thus be wary of investing in algorithmic stablecoins. It is clear with recent events that algorithmic stablecoins are Uncollateralized digital assets, which use financial engineering, algorithms, and market incentives to attempt to peg the price of a reference asset, are not stable at all and are always vulnerable.