Questions Swirl After Algorithmic Stablecoin Terra Loses, Regains Price Peg

Not much news takes place in mainstream markets over the weekend because they are closed. But there is always plenty of action in the 24X7 cryptocurrency markets.

The latest drama occurred over the past weekend and concerned the price volatility of algorithmic stablecoin Terra or UST. The stablecoin has been a center of news coverage about decentralized finance (DeFi) and cryptocurrencies in the last couple of months.

On Saturday, it lost its 1:1 peg to the U.S. dollar after investors withdrew UST holdings from various DeFi services. According to reports, the total deposits of UST at Anchor Protocol, which offers interest rates of as high as 20% for the stablecoin, fell from $14 billion to $11.2 billion. As of this writing, they are at $10.5 billion.

A wallet supposedly ‘dumped’ $84 million and $108 million worth of UST on Ethereum’s and Binance’s blockchain respectively.  Curve, one of the biggest liquidity pools in DeFi, also witnessed large scale withdrawals of Terra. All of this meant that Terra began trading at $0.987 to the US dollar. Rescue came in the form of an anonymous wallet that exchanged $200 million worth of UST for Tether.

Untested Economics

Interestingly, the hijinks in Terra’s price peg did not provide much validation for the economics of algorithmic stablecoins. Terra does not rely on backed fiat assets to maintain its US dollar price peg. A governance token LUNA is used as a counter to Terra’s USD coin. Its supply is increased or decreased based on Terra’s price. Thus, LUNA is destroyed when demand for Terra increases and it is minted when demand decreases. The fluctuations in supply create arbitrage opportunities for traders, who can redeem LUNA for Terra’s price peg and vice versa based on price movements for the respective tokens. On Saturday, Luna’s price also skidded downwards by 10% as Terra lost its price peg.  

According to Smart Stake, a data tracker for Terra, the total amount of LUNAs burnt over the weekend decreased marginally, from 141.88 million to 140.26 million, as UST experienced volatility in its price. In true crypto fashion, it took outside infusion from an anonymous wallet to recalibrate Terra’s price peg.  

Will LFG’s Plan Work?

This morning, the Luna Foundation Guard (LFG) tweeted that it was planning to deploy $1.5 billion in capital to “allay market concerns” and maintain Terra’s price stability. The capital deployment consists equally of Bitcoin and Terra. LFG is among the top three holders of Bitcoin along with MicroStrategy and Tesla.

But that strategy may not be a surefire success and questions will remain. Bitcoin’s price has crashed along with that of major mainstream assets. Aave, the other crypto in LFG’s reserves, has also slid with other crypto markets.

According to reports, mainstream investors are exiting their positions in crypto. It is unclear if a declining price for both of LFG’s reserve assets will help much in maintaining the stablecoin’s price peg to the US dollar. Derek Lim, head of crypto insights at Bybit – a crypto trading platform , told CNBC that LFG’s move will “add to the selling pressure” in crypto markets. “BTC will likely go lower before it bounces back when short-sellers take profit,” he said.

For LFG, the transaction may not be a profitable one because the foundation began its purchases of bitcoin at a high price last year. But Do Kwon says the stablecoin is not trying to exit its Bitcoin position. The eventual goal, according to him, is to replace LUNA with Bitcoin as a reserve asset.