After dominating headlines in May, UST has been a strong talking point in the crypto industry. The cryptocurrency, also known as TerraUSD, has been a central point of concern for regulatory bodies with regard to regulating stablecoins. Let’s explore what UST is, and why its recent turmoil is so serious.
UST, an algorithmic stablecoin
TerraUSD (UST) is an algorithmic stablecoin built on the Terra blockchain. The cryptocurrency is designed to be pegged to the US dollar, meaning that it will always be worth $1, maintained through an intricate token mechanism, making it an algorithmic stablecoin. With the rise of decentralized finance, stablecoins have gained traction both within and outside of the digital assets industry.
How Does UST Work?
This mechanism uses smart contracts and the platform’s native token Terra (LUNA) to manage the value through a mint/burn process. In order to mint UST, you need to burn LUNA and visa versa.
Most stablecoins pegged to a traditional currency or commodity will hold the underlying asset in reserve, ensuring that for every stablecoin issued there is an equal amount of the backing asset. For example, for every USDC issued, there is $1 held in reserves.
In the case of UST, instead of keeping a reserve of money, the stablecoin uses LUNA to maintain its one-dollar price. Algorithms built into the smart contracts track the supply and demand of both UST and LUNA which are responsible for maintaining UST's price. The UST peg is essentially LUNA tokens.
When the UST price rises, users can sell their LUNA back to the blockchain (earning a profit), and the algorithm will convert LUNA to UST causing the UST price to decrease. The same happens when the UST price decreases; UST holders can sell their UST back to the blockchain which is burned and then LUNA is minted thereby increasing the UST price.
While stablecoins have a reputation for being less volatile, this case has proven that algorithmic stablecoins can be considered a risky asset. When trading with financial products ensure that you get professional investment advice, even in the traditional finance sector.
Why Did The Terra Blockchain Crash?
In theory, if the demand for UST declines and it loses its dollar peg (unpegs from the USD value), then LUNA will be sold to reinstate the value. Another contributor to the pegging of UST is the Luna Foundation Guard which can add collateral should the stablecoin devalue. In recent months the well-funded organisation has been acquiring large amounts of Bitcoin that can later be used to protect its price.
While this is effective in most situations, it failed when the market’s interest (and market capitalization) in LUNA and UST plummeted in a matter of hours. The turbulent market led to significant UST falls.
The stablecoin first fell under $1 on 9 May when a whale sold a large amount of the digital currency, and while it managed to recover for a few days, derailed entirely dropping to $0.17 in a matter of days. According to CoinMarketCap at the time of writing, the Terra blockchain has officially halted.
At the same time, investors’ trust in LUNA also derailed, resulting in the coin’s market cap dropping below that of UST’s. As LUNA plays an active role in stabilising the price of UST, it became clear that the project did not hold the reserves in order to make this happen, leading many investors to sell the asset. Both LUNA and UST’s prices have plummeted.
Why Did This Affect The Rest Of The Crypto Market?
In an attempt to recover the price of UST, the Luna Foundation Guard sold some of their Bitcoin reserve, causing the Bitcoin price to drop. Watching what was happening to the Terra ecosystem, many investors became nervous and pulled their money from crypto investments, causing further declines across the cryptocurrency market.
Thankfully, these price declines were short lived and Bitcoin recovered to $30,000 at the time of writing. While there is still plenty of value to be gained before reaching the highs experienced late last year, the market is at least heading in the right direction.
While crypto winters are feared by many, remember that this offers the decentralized market a “rejuvenation” period where unstable projects close and an opportunity for investors to enter the market at deflated price points.