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

What happens when a “stablecoin” isn’t so stable? Investors are trying to make sense of what’s going on with a popular token known as TerraUSD, the world’s fourth largest stablecoin, which has failed to maintain its value relative to the U.S. dollar.

Here’s what investors need to know:

What is an algorithmic stablecoin?

A stablecoin is a type of cryptocurrency whose value is pegged to other assets, usually fiat currencies such as the U.S. dollar. They are designed to maintain a stable price, which makes them popular when it comes to facilitating trading, lending, and borrowing of other digital assets.

Some stablecoins, such as USDT

and USDC
are backed by reserves including U.S. dollars, cash equivalents and other assets. Others, such as TerraUSD
or UST, attempt to maintain their pegs through algorithms. 

What is Terra? How does it work?  

Terra is the world’s largest algorithmic stablecoin and the 11th largest cryptocurrency by market capitalization as of Tuesday, according to CoinMarketCap. Terra aims to maintain a one-to-one peg against the U.S. dollar through an algorithm that controls the supply of UST and an associated cryptocurrency called LUNA

Investors are supposed to be able to exchange one UST for $1 worth of LUNA, and vice versa. When UST is trading below $1, traders have incentive to buy one UST and exchange it for $1 worth of LUNA to make a profit. As UST is burnt to mint LUNA, the former’s supply would be reduced and its price will be pushed up. When UST is trading above $1, traders could be incentivized to exchange their LUNA for UST. As UST’s supply increases, its price would fall.

Terra grew at a breakneck speed — LUNA’s price surged from about $7 in July to an all time high of $120 in April, before it fell to $17, according to CoinDesk data. Anchor, a popular lending application on Terra that pays interest of up to 20% on crypto deposits, saw the value locked on the protocol up from $1 billion in July 2021 to a peak of $17.2 billion on May 5, before it fell 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 it climbed back to $1 on Sunday. On Monday, the stablecoin lost its peg again, falling to 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 plunged, with its price down about 50% over the past 24 hours to around $16, according to CoinDesk data. The token’s market capitalization has shrunk from more than $29 billion seven days ago to about $6.5 billion, according to CoinGecko.

What’s the impact on the crypto ecosystem? 

Investors are worried the fall of UST may add to selling pressure on bitcoin
which is already trading at a 10-month low. Some speculated that as UST lost its peg, its backers would have to sell off their $3.5 billion bitcoin reserves to support the stablecoin.

Luna Foundation Guard, which backs the Terra ecosystem, voted to issue $1.5 billion in loans, with half in bitcoin, to back the cryptocurrency, Do Kwon, founder of Terraform Labs, which powers the blockchain, wrote on Twitter on Monday.

A representative of Luna Foundation Guard didn’t immediately respond to an email seeking comment. Kwon didn’t respond to a request for comment.

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

Read: Yellen says run on UST stablecoin illustrates crypto’s risk to financial stability

Why did UST’s peg break?

A large amount of UST was withdrawn from the most popular applications on Terra starting Saturday, blockchain data shows.

Anchor saw an outflow of more than 4.6 billion UST over the past seven days, starting on May 7 and accelerating on May 9, while some addresses are recurring for large and early outflows, noted Aurelie Barthere, principal research analyst at crypto data analytics firm Nansen. 

Reasons behind the intensive UST outflow remain unclear. Some analysts attributed UST’s woes to a loss of confidence among investors.

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

Terra’s model “required a perpetual reliance on an assumption that there would be enough (ongoing) interest in the various use cases of UST in the Terra ecosystem (including unsustainable yields on the Anchor protocol), enough support from the crypto reserves being compiled, enough trading fees to add to those reserves when they were depleted, and enough willing arbitrageurs to constantly ensure a peg without ‘stepping-back’ from the ecosystem,” Clements wrote. 

What’s next? 

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

“I’m sure they will figure out a way to fix the peg, but they’re just gonna have to spend a lot of money to do it,” Clara Medalie, strategic initiatives and research director at Kaiko, told MarketWatch in an interview. 

Even if the peg is restored, some are worried that investor confidence will be hard to recover. “I think the whole story is so classic crypto. You’ve never seen so much hype over the past couple of weeks as you have for UST, for decentralized, algorithmic stablecoin, and it’s just crazy how quickly it unraveled,” Medalie said. “It very much captures a lot of hopes for crypto and how stuff can go so wrong, that is untested.” 

Crypto investors are also watching regulators’ moves in light of recent events, particularly “whether there is going to be some form of collateralization requirements that will get imposed on all projects that want to offer stablecoins,” said Michal Benedykcinski, senior vice president at crypto asset manager Arca. 

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