UST stablecoin fights for stability, rattles crypto market

Posted: 10 May 2022 3:45 pm

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As UST falls below $1, sister coin LUNA plummets. The fallout also stings Bitcoin on a day when it hit a longtime low below $30,000.

TerraUSD (UST), a stablecoin backed by the Terra ecosystem and pegged to the US dollar, has lost its peg in the past 24 hours, with its value falling below $1.

The move lower also impacted its sister coin LUNA, which saw its value drop by more than 54%. UST, an algorithmic stablecoin, is leveraged with Luna to keep its value at $1.

That also contributed to a rough span for Bitcoin, as the Luna Foundation Guard used its BTC reserves to try to keep UST at $1. Bitcoin and the crypto market have been struggling with the stock market, but BTC hit a longtime low below $30,000 in the past 24 hours.

The drop in UST and LUNA cryptocurrencies caused massive withdrawals from Terra DeFi platforms where the total value locked within 24 hours dropped from around $29 billion to $12 billion, according to DeFi Lama.

However, the struggle could be an opportunity for some. If you can buy UST below the peg — it’s traded as low as 68 cents and at this writing trades at 91 cents — and sell it when it returns to the peg, you can make a quick profit. But if the peg fails for good, both UST and LUNA will lose their value.

How UST maintains its peg

Unlike other stablecoins like USDC where each USDC is directly backed by one US dollar kept in a bank or other US securities, UST relies on so-called smart contracts to increase or decrease its supply through algorithms.

When the UST value drops below its $1 peg, as it did briefly last weekend as well as this week, the algorithm burns UST to reduce its supply until the peg is restored. If the value still doesn’t reach parity, the algorithm releases seigniorage shares.

Seigniorage shares are similar to bonds. Users buy them at a discount with their UST to reduce the circulating supply even more.

Another method of keeping the peg utilizes the LUNA token. This is Terra’s native utility and governance token, which holders can stake to earn rewards. When UST falls below the $1 peg, the algorithm incentivizes holders to burn UST in exchange for LUNA, again to reduce UST’s supply.

The premise here is that $1 UST can always be redeemed for $1 worth of LUNA. If LUNA trades at $35, you can redeem it for $35 UST. And vice versa, you can buy one LUNA for $35 UST.

To protect the peg, if UST trades below $1 — say, 90 cents — you have an incentive to buy UST and trade it for $1 worth of LUNA. This swapping is meant to stabilize the price.

Luna Foundation Guard (LFG) assists in keeping the peg

The Luna Foundation Guard is a nonprofit organization with the goal to help build and promote a decentralized economy. Aside from supporting research and development of open-source software and applications on the Terra blockchain, the LFG has established a decentralized UST reserve protocol to safeguard the UST peg.

If none of the algorithmic measures keep UST at $1, LFG can deploy its own funds to restore the peg. Recently, LFG bought $1.5 billion worth of Bitcoin, which is being used to preserve the UST peg. LFG also holds AVAX, LUNA and UST.

In the past 24 hours, LFG deployed $750 million in BTC to market makers to buy UST and counter the effects of panic selling. But this is being widely credited for causing Bitcoin selling pressure, since it creates more sellers than buyers.

On the flip side, this can be a win for the LFG as well. They’ve also deployed $750 million in UST to market makers to buy back Bitcoin. If the price of BTC falls further, they can buy it at a lower price than what they bought at before — around $40,000.

It’s all a complex balancing act, and how it will work out remains to be seen.

What happens now?

There are two scenarios: the UST peg is restored or its value continues falling.

This isn’t the first time UST lost its peg. In December 2020, UST traded at 85 cents — luckily it recovered in a day. In the past 24 hours, UST traded at 68 cents at one point and is yet to recover, trading at 91 cents at the time of this writing.

If the LFG restores the peg, this could be a solid short-term opportunity to earn some money. However, the risk of UST completely losing the peg remains. In this scenario, you might lose all your money.

Interested in cryptocurrency? Learn more about the basics with our beginner’s guide to Bitcoin, dive deeper by learning about Ethereum and see what blockchain can do with our simple guide to DeFi.

Kliment Dukovski owns cryptocurrencies as of the publishing date.

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