CryptocurrencyWeb3NFTsInvestingBitcoin

A ‘stable’ coin lost its peg over the weekend and pledged $1.5 billion in Bitcoin trying to stabilize. Here’s how the algorithmic stablecoin was supposed to work—and didn’t

May 10, 2022, 6:49 PM UTC

TerraUSD (UST) was supposed to be the standard-bearer of algorithmic stablecoins, but the turmoil gripping markets is exposing flaws that critics have long charged it with.

After losing its peg over the weekend, the Luna Foundation Guard (LFG), an association meant to support the cryptocurrency, said it would issue $1.5 billion in loans denominated in Bitcoin and UST to stabilize it. 

But after days of triage by LFG, the UST stablecoin still hasn’t regained its peg. In other words, one UST is still worth less than $1. On Monday, it fell as low as 66 cents before recovering to about 90 cents at the time of publication.

The idea behind stablecoins is that investors use them as a “safe” cryptocurrency asset. They are tied to the price of a fiat currency like the U.S. dollar, so in theory, one stablecoin pegged to the dollar is always worth at least $1.

UST is an algorithmic stablecoin created by South Korean crypto developer Do Kwon and his company Terraform Labs. These differ from other stablecoins because they have no reserves; they hold their value based on an algorithm that automatically strikes a balance between the stablecoin and a partner coin. 

UST is the most popular algorithmic stablecoin and the third-largest stablecoin overall by market capitalization. It (theoretically) maintains its dollar peg through an algorithm that encourages traders to take advantage of any price changes in the stablecoin.

The system relies on traders burning or creating tokens for profit to maintain its peg to the U.S. dollar. This process works through UST’s pairing with its sister cryptocurrency, Luna. Every time a UST token is minted, the equivalent of $1 in Luna is burned, and vice versa. So when the price of UST drops below $1, traders are encouraged to burn UST, or remove it from circulation, and receive Luna tokens at a discounted rate. Because there is less UST changing digital hands, the price should theoretically go up toward $1 again, maintaining the peg.

If the price of UST exceeds $1, traders are incentivized to burn Luna in exchange for a dollar in UST, which increases its supply and theoretically will eventually drop the price back to $1.

What’s not supposed to happen is for UST to fall below $1—and then keep dropping.

UST runs into problems

On Saturday, the UST stablecoin lost its peg to the U.S. dollar and then again on Monday. As of Tuesday afternoon, the stablecoin was still off its dollar peg by about 10 cents. 

The root of the problem seemed to be in the crypto market, as UST deposits in Anchor fell from $14 billion to $11.2 billion over the weekend.

UST being so reliant on Anchor has been a source of criticism in the crypto community, since Anchor’s yields may well be inflated by huge backers, including Do Kwon himself and his billions worth of crypto.

As the UST stablecoin dropped, it brought its sister coin down with it. The large withdrawals of UST from DeFi platforms tanked Luna, which as of Tuesday afternoon was down more than 40% to about $30.52 over the preceding 24 hours, according to CoinMarketCap.

Terraform Labs did not immediately respond to Fortune‘s request for comment.

CoinDesk reported on some conspiratorial events surrounding the “de-peg” as well: On Saturday, one cryptocurrency wallet dumped $84 million worth of UST on Ethereum and $108 million on Binance’s exchange, prompting some members of the Terra community to call the de-peg a “coordinated attack.”

Sounding the alarm

Ryan Clements, a professor of business law and regulation at the University of Calgary who has studied algorithmic stablecoins, has been warning people about their inherent riskiness since publishing a report for the Wake Forest University Law Review in October 2021.

Clements told Fortune that because the stablecoins lack reserves to back them, the value of algorithmic stablecoins like UST is perception- and demand-based.

“Therefore, algorithmic stablecoins like UST aren’t intrinsically stable,” he told Fortune via email.

Lacking reserves puts UST in particular at the will of various assumptions, Clements said, including those that there will be ongoing interest in the use cases of UST and that there will always be enough traders with accurate price information taking advantage of when UST falls below a dollar to keep the stablecoin in check.

“UST essentially got out over its skis and now needs to walk back,” Dustin Teander, a research analyst at Messari, told Fortune. “It’s largely there with the supply decreasing over $2 billion,” he added, saying it is now likely on the path back to stability.

Clements acknowledged that UST has been valuable to traders in staking, or locking up cryptocurrency to earn passive income on it, as well as a way to move money from centralized finance, like banks, to decentralized finance applications on the blockchain. But he stops short of calling UST stable. 

In his October report, Clements was already warning that a market downturn could negatively affect UST because of its reliance on a baseline of support, traders willing to engage with it, and the availability of clear information which he said can get muddled during downturns.

“None of these factors are certain, and all of them have proven to be highly tenuous in the context of financial crises or periods of extreme volatility,” Clements wrote in the October 2021 report.

Yet, as of Tuesday afternoon, the algorithmic stablecoin was still not trading at $1. In a tweet just before noon on Tuesday, Do Kwon said he was “close to announcing a recovery plan” for UST.

Meanwhile, a pseudonymous crypto trader who bet Kwon $10 million that his Luna cryptocurrency would be trading below $88 in March 2023 has now put another $10 million in the pot, according to crypto outlet the Block. With Luna trading at close to $30, he’s currently ahead.

Sign up for the Fortune Features email list so you don’t miss our biggest features, exclusive interviews, and investigations.