Terra Is Living Proof That Stablecoins Aren’t As “Stable” As They Seem

Jonathan Hobbs

about 2 months ago2:51 mins

Terra Is Living Proof That Stablecoins Aren’t As “Stable” As They Seem

The cracks began to show over the weekend for bluechip blockchain Terra, when its TerraUSD (UST) stablecoin detached from its US dollar peg. The shakeup has sent the price of Luna – UST’s more volatile counterpart – down more than 60%, knocking the crypto out of the top 10 digital assets by market size. So let’s investigate what happened, and what it might tell you about stablecoins as a whole.

What’s the relationship between UST and Luna?

First, a bit of background on the relationship between UST and Luna.

Terra’s blockchain ecosystem uses crypto technology to do what the traditional financial system does, but with algorithmic stablecoins that track the price of fiat currencies. For example, TerraUSD (UST), the largest algorithmic stablecoin, tracks the US dollar, and TerraKRW (KRT) tracks the South Korean won.

As with other cryptocurrencies, you can rapidly ping stablecoins across the blockchain with minimal fees – and without using the banking system. But unlike with more volatile digital assets, the value of those stablecoins (in theory) stays pegged to the value of a fiat currency.

Terra’s algorithm usually keeps its stablecoins pegged to the value of fiat currencies through its relationship with Terra’s Luna token – the main source of collateral for Terra’s stablecoins. To mint UST (or any other Terra stablecoin) an equivalent amount of Luna must be “burned” – i.e. transferred to a Luna wallet address that’ll no longer be used. And the same goes for minting Luna, where UST is burned to lower its supply.

If UST is trading at $1.10, for example, Luna holders can burn their Luna to mint UST and make a 10 cents profit (less a small fee). The supply of UST then goes up, bringing its value back in line with the dollar. But if UST is trading at 90 cents, UST holders can burn their tokens to mint Luna, and make a 10 cents profit (less a small fee). This reduces the amount of UST in circulation, which brings the value back to a dollar – or at least, that’s what was happening until recently…

So what exactly happened with Terra?

Last weekend, the UST stablecoin slipped its peg to the US dollar, and by Tuesday it was trading at less than 62 cents.

TerraUSD price versus the US dollar on Coinbase. Chart prepared with TradingView.
TerraUSD price versus the US dollar on Coinbase. Chart prepared with TradingView.

So far, there isn’t a single prevailing view about why this happened. Some believe the tremors were part of a coordinated attack on Terra, launched when a particular “whale,” or heavy trader, sold $285 million worth of UST on DeFi protocol Curve Finance. Meanwhile, others believe it was a cumulative effect of lost confidence in Terra's algorithmic stablecoin function, along with general market jitters.

Regardless of what caused this upheaval, one thing is clear: confidence in Terra is shaken. And we can see this in Luna's price, which has dropped more than 60% since the commotion began last weekend.

Luna price vs. the US dollar. Chart prepared with TradingView.
Luna price vs. the US dollar. Chart prepared with TradingView.

Terra is one of the biggest blockchains out there, which is why this debacle has rattled the whole market.

What’s the lesson here?

Like many crypto investors and traders, you might hold stablecoins to reduce the volatility of your crypto portfolio. If you’re going to do this, it’s better to spread the risk by holding a few different stablecoins rather than just one.

The other lesson is this: even the most promising crypto projects have massive risks. Up until now, Terra was widely considered a top bluechip blockchain, with Luna rallying from under 30 cents a coin in November 2020 to over $100 just a month ago. But this event has complicated the market’s view of Terra – and highlighted the importance of diversifying your crypto bets.

If Terra can somehow pull itself out of this mess, there might be a long-term opportunity for Luna to salvage itself – but it’s far too soon to speculate. First, the market will want to see UST return to its peg against the US dollar – and stay there for a few months without any hiccups. Perhaps then, confidence in Terra could slowly return.

Around 40% of Luna’s token supply is locked up for staking, according to stakingrewards.com – and can’t be accessed for 21 days. Once Luna stakers have access to their coins again, they may well wish to sell them – especially if the peg remains unstable.

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