Crypto is surviving
The crypto crash of last week dealt many people a blow, especially ‘regular, hardworking people’ who don’t have funds behind them to soften the blow. Some people lost all of their money in the LUNA/UST crash.
To recap on what happened: terraUSD (UST), a cryptocurrency that is supposed to stay at $1 (it’s a stablecoin), is now way below that valuation. At the time of writing it is worth $0.145577. LUNA, the crypto token that backs UST, also lost virtually all of its value, but is regaining strength today.
Stablecoins exist so that crypto-natives can get in and out of the dollar easily without needing a bank to approve deposits and withdrawals. Stablecoins facilitate most crypto trading volume and power DeFi. The best known stablecoins are Tether (USDT) USD Coin (USDC) and Binance USD (BUSD). And then along came terraUSD (UST), which became popular pretty quickly. Three of these stablecoins (USDT, USDC, BUSD) are collateralized stablecoins issued by centralized entities. These entities own a treasury of dollars that back each coin so that each coin can be redeemed for $1 by the holder from the issuer.
UST is different, because it isn’t collateralized. It is an algorithmic stablecoin, powered by the Terra protocol and backed by a crypto token called LUNA.
How does that work?
The theory of making it work is this:
- When UST’s price is too high (>$1), the protocol incentivizes users to burn (destroy) LUNA and mint (make) UST.
- When UST’s price is too low (<$1), the protocol incentivizes users to burn (destroy) UST and mint (make) LUNA.
If the demand for UST is high enough to increase its price to $1.01, the protocol prints some UST in exchange for getting rid of some LUNA. It’s pretty simple, and was working efficiently, until last week.
It wasn’t that the mechanism broke. Indeed the protocol tried to algorithmically bring UST back to $1 while LUNA’s price was also tanking.
A rescue plan was announced by Terraform Labs (the company behind Terra) to buy $10 billion worth of Bitcoin and other crypto assets to act as a backstop. It didn’t work, because UST wasn’t fully collateralized like the other stablecoins. Furthermore, just before the collapse, UST’s market capitalization was $18 billion, way more than the $4 billion held in reserve. Between UST and LUNA, over $40 billion of value was lost.
The lesson to be learnt from this is that an undercollateralized, algorithmic stablecoin will fail no matter how long it succeeds for. And as the crypto markets start to rebound after last week’s crash, we must consider that we have been incredibly lucky that UST and LUNA aren’t big or intertwined enough to cause mass hysteria across all markets.