article

What's going on with the Terra stablecoin?

Author
Trent Fowler
Date
May 11, 2022

The Case of the Unstable Stablecoin

Over the weekend, investors in UST, the stablecoin for the Terra blockchain, and its sister coin LUNA were spooked when billions of dollars of UST was abruptly withdrawn from Anchor, a high-yield protocol which basically functions like a blockchain bank on the Terra blockchain.

Then on Monday, the situation further deteriorated as the price of UST dropped from $1 to $0.98. Though a $.02 drop may not seem like a lot in a space famous for its volatility, it’s quite significant when talking about stablecoins, assets whose entire purpose is to stay firmly pegged at $1.

This drop triggered mass sell-offs and sent the price of UST into a free fall. At its lowest point, UST hit a stunning low of $0.66, and it is now hovering at a relatively anemic $0.91.

Some believe this is the natural consequence of the unsound mechanics of algorithmic stablecoins, while others maintain that it was a coordinated plot to make hundreds of millions of dollars by gaming UST to short bitcoin (BTC). To gain greater clarity on these issues, we need to take a step back and put some context into place.

The Pixie Dust of Algorithmic Stablecoins

UST is an algorithmic stablecoin, but what is a stablecoin and how does it work?

A stablecoin is a crypto asset meant to be pegged to one unit of a government-backed currency, such as the dollar, without ever deviating from that value.
Standard stablecoins are often backed by Treasury securities, cash, and other forms of dollar-denominated debt as a means of keeping their value, well, stable.

Algorithmic stablecoins, on the other hand, are not backed by any assets, relying instead on financial engineering, incentives, and trader activity to maintain their value.

A crucial requirement for understanding the current situation is the relationship between UST and another crypto asset, LUNA.

Family Ties

So if UST is an algorithmic stablecoin, what blend of financial engineering and incentives does it use to maintain its stability?

UST’s success and stability is intertwined with its sibling, LUNA, which creates arbitrage opportunities that, in theory, should keep UST’s price steady.

If UST’s price drops below one dollar, it can be ‘burned’ (permanently destroyed) in exchange for LUNA, which lowers the supply of UST and raises its price. Conversely if UST’s price goes above a dollar, LUNA can be burned in exchange for UST, which increases the supply of UST and decreases its price.

As long as conditions are normal and everything is functioning correctly, this creates both a mechanism and incentive for keeping the price of UST at one dollar.

When a Stablecoin Is Not So Stable

The problem is that market conditions have not been normal. Even leaving aside the possibility that the de-pegging event was deliberately engineered, with major recent price corrections across traditional finance and crypto, maintaining the peg would have been very tricky anyway.

Though algorithmic stablecoins are not usually backed by assets like other stablecoins, the organization responsible for developing UST and the broader Terra ecosystem, the LUNA Foundation Guard (LFG), has nevertheless built a warchest of BTC to be used in the event that the UST becomes depegged from the dollar. The idea is that if UST’s price ever drops significantly, the BTC can be loaned out to traders who’ll use it to buy UST and push the price back up, re-pegging it to the dollar.

So, when UTC went into a deep dive, LFG deployed more $1.3 billion dollars worth of BTC (42,000 coins at a price of $31,000 each) to traders who will use it to purchase UST, creating demand pressure and bolstering its price.

We’re watching in real time as they put this strategy to the test.

Bitcoin funds moving out of a wallet.

In Elementus PulseTM we see 42,000 BTC leave the LFG wallet (the red ‘Source’ node) to other addresses in a bid to bolster UST’s price and re-peg it to the dollar.

In the meantime, several exchanges have frozen transactions of UST, and the broader crypto community waits to see how the LFG will try to handle this major test of its technology.