What is an algorithmic stablecoin? Why is Terra in the news? Here’s what investors need to know.

What happens when a “stablecoin” is not that stable? Investors are trying to understand what’s going on with a popular token called TerraUSD, the world’s fourth-largest stablecoin, which has failed to hold its value against the US dollar.

What is an algorithmic stablecoin?

A stablecoin is a type of cryptocurrency whose value is pegged to other assets, typically fiat currencies like the US dollar. They are designed to maintain a stable price, making them popular when it comes to facilitating the trading, lending, and borrowing of other digital assets.

Some stablecoins, like USDT USDTUSD,
are backed by reserves including US dollars, cash equivalents and other assets. Others, like TerraUSD USTUSD,
or UST, attempt to maintain their ties through algorithms.

What is Terra? How does it work?

Terra is the world’s largest algorithmic stablecoin and the 11th largest cryptocurrency by market cap as of Tuesday, according to CoinMarketCap. Terra aims to maintain a one-to-one peg to the US Dollar through an algorithm that controls the supply of UST and a related cryptocurrency called LUNA LUNAUSD.

Investors should be able to exchange one UST for $1 worth of LUNA and vice versa. When UST is trading below $1, traders have an incentive to buy one UST and trade it for $1 worth of LUNA to make a profit. As UST is burned to mint LUNA, the former’s supply would be reduced and its price inflated. If UST trades above $1, traders could be incentivized to trade their LUNA for UST. If UST’s supply increases, its price would fall.

Terra grew at breakneck speed – LUNA’s price surged from around $7 in July to an all-time high of $120 in April, according to CoinDesk data, before falling to $17. Anchor, a popular lending application on Terra that pays interest of up to 20% on crypto deposits, saw the protocol’s value plummet from $1 billion in July 2021 to a peak of $17.2 billion on March 5 May rose before falling to $5.9 billion on Tuesday, according to data from DefiLlama.

Why is Terra in the news?

TerraUSD briefly fell to around 99 cents on Saturday before climbing back to $1 on Sunday. On Monday, the stablecoin lost its peg again, falling as low as 61 cents on crypto exchange Binance. It is recently trading at around 79 cents, well below the crucial $1 level.

Luna also crashed, with its price down about 50% to around $16 over the past 24 hours, according to CoinDesk data. The token’s market cap has shrunk to about $6.5 billion from more than $29 billion seven days ago, according to CoinGecko.

What is the impact on the crypto ecosystem?

Investors fear UST decline could increase selling pressure on Bitcoin BTCUSD,
which is already trading at a 10-month low. Some speculated that if UST lost its peg, its backers would have to sell their $3.5 billion Bitcoin reserves to back the stablecoin.

Luna Foundation Guard, which supports the Terra ecosystem, voted to issue $1.5 billion in loans, half of it in Bitcoin, in support of the cryptocurrency, Do Kwon, founder of Terraform Labs, which developed the blockchain drives wrote on Twitter On Monday.

A Luna Foundation Guard representative did not immediately respond to an email seeking comment. Kwon did not respond to a request for comment.

Meanwhile, Treasury Secretary Janet Yellen mentioned TerraUSD in testimony before the Senate Banking Committee on Tuesday, saying the event “shows this is a fast-growing product” that poses “risks to financial stability.”

Read: According to Yellen, the run on UST stablecoin highlights the risk of crypto to financial stability

Why did UST’s pin break?

Blockchain data shows a large amount of UST has been withdrawn from the most popular applications on Terra as of Saturday.

Anchor saw more than 4.6 billion UST outflows over the past seven days, beginning on May 7 and accelerating on May 9, while some addresses for large and early outflows bounce back, noted Aurelie Barthere, senior research analyst at the crypto data analysis firm nansen

The reasons for the intense UST outflow remain unclear. Some analysts attributed UST’s troubles to a loss of investor confidence.

“Algorithmic stablecoins are based on trust in the economic incentives of the stablecoin issuer’s underlying ecosystem. Once that confidence and investor demand has evaporated, they quickly fail in a death spiral,” Ryan Clements, a University of Calgary professor who has conducted research on algorithmic stablecoins, told MarketWatch via email.

Terra’s model “required an ongoing reliance on the assumption that there would be enough (sustained) interest in the various use cases of UST in the Terra ecosystem (including unsustainable returns of the Anchor Protocol), enough support from the crypto reserves that put together, enough trading fees to add to those reserves when they are depleted, and enough willing arbitrageurs to continuously ensure commitment without withdrawing from the ecosystem,” Clements wrote.

What’s next?

Kwon tweeted on Tuesday that a recovery plan for UST is near:

“I’m sure they’ll find a way to fix the clamp, but they just have to spend a lot of money to do that,” Clara Medalie, Strategic Initiatives and Research Director at Kaiko, said in an interview with MarketWatch.

Even if the bond is restored, some fear investor confidence will be difficult to restore. “I think the whole story is so classic crypto. They’ve never seen as much hype as UST, a decentralized algorithmic stablecoin, over the past few weeks and it’s just insane how quickly it’s dissipated,” Medalie said. “It raises a lot of hopes for crypto and how things can go so wrong, that’s untested.”

Crypto investors are also watching regulators’ moves in light of recent events, specifically “whether there will be some form of collateral requirements that will be imposed on all projects that want to offer stablecoins,” said Michal Benedykcinski, senior vice president at crypto asset manager Arca. What is an algorithmic stablecoin? Why is Terra in the news? Here’s what investors need to know.

Brian Lowry

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