The cracks began to show over the weekend for the Terra blockchain, when its stablecoin TerraUSD (UST) broke away from its peg to the US dollar. The shakeup has caused the price of Luna, UST's most volatile counterpart, to drop more than 60%, eliminating the cryptocurrency from the top 10 digital assets by market size. Let's investigate what happened and what we might think about stablecoins as a whole.
What is the relationship between UST and Luna?⚖️
Terra's blockchain ecosystem uses cryptographic 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 quickly ping stablecoins on the blockchain with minimal fees and without using the banking system. But unlike more volatile digital assets, the value of those stablecoins (in theory) remains tied to the value of a fiat currency.
Events that occurred with the UST peg.
Terra's algorithm generally keeps its stablecoins pegged to the value of fiat currencies through its relationship with the 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 will no longer be used. And the same goes for Luna minting, where UST is burned to lower its supply. If UST is trading at $1.10, for example, Luna holders can burn their LUNA tokens to mint UST and make a profit of 10 cents (less a small fee). The supply of UST then increases, 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 profit of 10 cents (less a small fee). This reduces the amount of UST in circulation, bringing the value back to one dollar, or at least, that's what was happening until recently...
So what exactly has happened to Terra? ⚠️
Last weekend, the UST stablecoin slipped from its peg to the US dollar and was trading below 62 cents on Tuesday. So far, there is no single prevailing opinion as to why this happened. Some believe the tremors were part of a coordinated attack on Terra, launched when a particular "whale," or large merchant, sold $285 million in UST on the DeFi Curve Finance protocol. Meanwhile, others believe it was a cumulative effect of loss of confidence in Terra's algorithmic stablecoin feature, along with general market nervousness.
95% drop in Terra's native token, LUNA.
Regardless of what caused this disorder, one thing is clear: trust in EARTH It staggers. And we can see that in the price of Luna, which has dropped more than 60% since the hype began last weekend. Terra is one of the largest blockchains out there, which is why this debacle has shaken the entire market.
What is the lesson here?
Like many cryptocurrency investors and traders, we can hold stablecoins to reduce the volatility of our cryptocurrency portfolio. If we are going to do this, it is better to spread the risk by holding a few different stablecoins instead of just one. The other lesson is that even the most promising crypto projects have massive risks. Until now, Terra was widely regarded as one of the best blockchains, with LUNA rising from less than 30 cents per coin in November 2020 to over $100 just a month ago. But this event has complicated Terra's market view and highlighted the importance of diversifying its crypto bets.
Comparison of two diversified portfolios. Source:Quadency
If Terra can somehow get out of this mess, there might be a long-term chance for Luna to save herself, but it's too early to speculate. Firstly, the market will want to see the UST return to its peg against the US dollar and stay there for a few months without a hitch. Perhaps then, trust in Terra could slowly return. Nearly 40% of Luna token supply is locked for staking, according to Stakingrewards.com, and cannot be accessed for 21 days. Once investors who staked Luna have access to their coins again, they may want to sell them, especially if the UST peg remains unstable.