Since the start of this week, news regarding open-source blockchain protocol Terra has swept through the crypto and DeFi industry. The network has seen its native currency LUNA experience 3 consecutive days of negative price action.
On the 8th of May the token recorded losses of about 10%, and its value plunged to 65.80 USD. The next day saw the token slide even further, cutting its value down to about half of this figure. According to data on coinmarketcap LUNA, at the time of writing LUNA is trading at $2.06 having fallen 93.46% within the last 24 hours.
This becomes more shocking considering the digital token’s $119 record high, set a little over a month ago. LUNA has lost up to 92% of that value since reaching that peak and fluctuations within the past day have sent it towards figures that have not been seen for almost a year. Charts show dips down to $0.8384, a remarkably low value.
As the token progresses on this decline, suicide hotlines continue to flood Terra’s Reddit page as waves of panic spread among users. Sentiment across the industry attributes these developments to the recent de-pegging of the network’s USD-backed stablecoin TerraUSD (UST).
We’ll be exploring these happenings and their potential implications. However, before that let’s go over what stablecoins and algorithmic stablecoins are, as well as other details related to this topic.
What are Stablecoins?
A stablecoin is a type of digital currency that attempts to offer users a measure of stability; its value is tied to a more stable currency such as the US dollar
or a valuable commodity like gold. The wider crypto market is plagued by volatility and price fluctuations and stablecoins exist to resolve this.
How stablecoins typically work is that the team behind the project sets up a reserve to store quantities of the backing asset. The funds in the reserve serve as collateral, each time a stablecoin user withdraws some of their holdings, a quantity of the backing asset (depending on the pegging ratio) is taken from the reserve.
Stablecoins vary based on the collateral asset, they are usually backed by fiat currencies, cryptocurrencies, and precious metals. Popular examples of these stablecoins include Tether
and USDC. There are stablecoins such as TerraUSD that aren’t collateralized at all, instead, the price fluctuations in these cases are regulated by a smart contract. These are known as algorithmic stablecoins, let’s take a look at how these work.
How do Algorithmic Stablecoins Work?
With an algorithmic stablecoin, the token is not backed by a reserve instead it retains its pegged value with the use of smart contracts. A prime example is UST.
Terra’s UST token is tied to the US dollar
in a 1 to 1 ratio, this means that 1 unit of UST is equal to a dollar. The stablecoin balances its value through arbitrage, a token minting and burning mechanism that leverages supply and demand to adjust the price. UST uses the LUNA token to maintain stability in this process.
When demand for UST rises and its price exceeds $1, LUNA holders can sell their tokens to the network for a profit. The algorithm converts the LUNA back into UST causing the price to drop once more funds are added to the UST pool. The reverse of this scenario is also the case, if UST decreases in price if the UST price declines, the stablecoin’s investors earn profits by converting their UST into LUNA coins. The smart contract reduces the pool and the scarcity results in a price surge.
Algorithmic stablecoins are generally criticized because of their complexity. The precarious relationship between UST and LUNA means if the balance is broken it will reflect on both currencies This describes the events of the past few days. The question now is what began this in the first place?
Why did the Price Drop?
No one has been able to state a specific reason but early this week, UST was de-pegged. The term describes stablecoins falling below $1 as with UST or going past the 1$ peg. TerraUSD fell as low as $0.298, some point towards a general crypto sell-off as the reason buyers weren’t interested in both LUNA and UST.
Traders began to exchange their de-pegged UST holdings for other stablecoins. With demand for UST dropping LUNA followed, the algorithm began minting more LUNA to counter this but they were unsuccessful and investors who had lost trust in the network began to sell their LUNA as well. Algorithmic stablecoins are sustainable in a bullish environment, the balance is maintained in cases of volatility as long as demand remains. However, when demand for the linked tokens suddenly disappears.
Besides the arbitrage mechanism, UST’s peg was also protected by something else; the LFG (Luna Foundation Guard). UST founder Do Kwon created the LFG to be a massive reserve that would function as collateral if UST’s price ever saw a huge dip. The LFG had been buying significant quantities of Bitcoin
amassing up to 2 billion dollars worth of the cryptocurrency.
As TerraUSD was de-pegged the reserve was swapped for UST and the price did recover a little. However, the unfortunate truth remains that the reserve simply wasn’t sufficient.
to blockchain researcher Mudit Gupta, what originally triggered the sell-off was some suspicious behavior unveiled in transactional data over the weekend. Large quantities of UST were removed from liquidity on DeFi protocol curve finance, and this caused the initial depegging.
Terraform labs took out about $150m worth of UST, from Curve, a minute after $84m worth of the stablecoin was bridged to Ethereum. A few minutes later the stablecoins were dumped leading investors to panic and sell off their holdings. Also, on Saturday 7th of May, a whale dumped about $285 million worth of TerraUSD tokens into the market
Do Kwon came forward to clarify that Terraform had removed funds from Curve to deploy into a different pool next week, however, they were not behind the ensuing dump.
Essentially, the dump led to an influx of UST tokens that dipped to $0.98; that is the initial depegging though slight. This sparked fear of greater depegging that resulted in people selling off their LUNA holdings which in turn caused it to fall.
What Does this Mean for the Broader Crypto Industry?
Before this UST was the crypto market’s 3rd largest stablecoin by market cap, however, according to DeFi yield platform Anchor, the project’s total value locked plunged by $11 billion in just 48 hours. This comes a week after it peaked at $17B.
This will likely translate into an industry-wide mistrust of stablecoins, although more established projects will probably stay unaffected. Investors have begun to take note of the risky nature of algorithmic stablecoins. Stablecoins generally might also experience a tighter regulatory crackdown, reports state that US treasury Janet Yellen pushed for a defined framework for stablecoins during a yearly testimony before the Senate Banking Committee held on Tuesday
What’s Next for UST?
Creator Do Kwon has shared detailed plans for the stablecoin’s recovery in a Twitter thread. He first explained,
Then shared a possible solution
To achieve this, terraform labs will have to expand USD’s base pool from $50m to $100m. The company also has to decrease the PoolRecoveryBlock from 36 to 18 to help improve the minting capacity from $239 million to around $1.2 billion Do Kwon pointed out that this will be costly to UST and LUNA hodlers but they have plans to explore more routes to draw exogenous capital towards the ecosystem.
Author: Gate.io Observer M. Olatunji
* This article represents only the views of the observers and does not constitute any investment suggestions.
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