May 12, 2022 · 5 min read

LUNA’s Crash Landing Is Taking UST Down With It

Three weeks ago, we took a look at algorithmic stablecoin protocol Terra (UST) and the risks associated with the methods used to maintain price parity with the fiat currency they represent. Since then, crypto market conditions have not been favourable. Bitcoin and Ethereum have both seen price drops in the region of 34% over the past month. Eyes are now closely watching the price of algorithmic stablecoins, as some (such as Terra’s UST) have been concerningly volatile. Yesterday, UST dropped to a value of just $0.29 - not even remotely close to its supposed Dollar peg. Currently, UST is trading at $0.54.

Price peg detachment is not a concept exclusive to cryptocurrency or DeFi. In traditional  fixed–exchange-rate regimes for fiat currencies (which are centrally-governed), central banks have the ability to sell foreign reserves to re-establish price parity by reducing the supply of its domestic currency. This can be thought of as a ‘supply-oriented’ solution. Unable to use this method, algorithmic stablecoin protocols rely on ‘demand-oriented’ methods such as arbitrage to maintain price parity. And in market conditions such as those we find ourselves in now - these methods are not the ideal solution and often result in price-detachment. Let’s dive into why algorithmic stablecoins like UST are struggling to stand the heat.      

Why Are Crypto Prices On The Slide Again?

The cause of crypto’s recent downturn is up for debate, but the most likely explanation is considered to be the recent meeting of the Federal Reserve. The result of the meeting was a 0.5% increase to its benchmark interest rate to combat concerningly high inflation. 

This represents the largest increase in more than 20 years and lowered the value of tech-heavy indexes such as the NASDAQ (which fell by almost 4% with the news) and of course - crypto. US inflation levels were assessed yesterday to be at 8.3% for the month of April, being the same figure as last month. This could mean a continuation of current bear market conditions.

How Are Stablecoins Affected?

Terra’s stablecoin - UST - is an algorithmic stablecoin meaning that it maintains parity through market incentives. In the case of algorithmic stablecoins, ‘arbitrageurs’ (people who exploit differences in price for profit through trading) and traders are essentially responsible for managing the stability of such stablecoins. UST is backed and redeemable by the platform’s governance token LUNA. It is this ability to swap UST for LUNA that maintains the price peg, as any discrepancy in price difference would present an opportunity to ‘correct’ the price difference for profit. Algorithmic stablecoin protocols offer convenience to the creators of the currency as they allow price parity to be handled by DeFi markets as opposed to through centralised governance. 

The problem with algorithmic price parity however is that it relies on market conditions being relatively predictable. In the case of UST, its stability is dependent on the price of Terra’s governance token LUNA. This week, LUNA’s value has been almost completely wiped out. The token is currently trading at just $0.05 - down from $84 this time last month. 

Essentially, algorithmic stablecoins are far less equipped to correct price differences in the event of a detachment. Terra does have reserves in the region of $2B worth of Bitcoin. However this value is not equal to the value of the ~15B UST in circulation. An additional $13B of collateral would be required to ensure that the protocol’s stablecoin can remain pegged to the value of the US Dollar.  

Non-algorithmic stablecoins such as Tether (USDT)  - the largest stablecoin by market cap - typically have every unit of their stablecoins backed by 1 unit of the fiat currency they represent (purportedly). This means that in the case of a significant price detachment, the treasury could have its reserves drawn down to reestablish the peg.  In the case of Tether, its significantly larger daily volume additionally provides a ‘cushion’ to soften the blow of large market downturns such as those seen this week. As a result, this kind of stablecoin does not suffer as greatly during periods of market volatility compared to algorithmic stablecoins. However even Tether has suffered. USDT is currently trading at just $0.98 - a rare occurrence for a stablecoin as large as Tether.     

(Source: R.K Lyons and Ganesh Viswanath-Natraj

As we explored last week, the methods by which stablecoins maintain price parity are crucial to their supposed ‘stability’. Not having stable backing for each unit creates risk in uncertain market conditions. UST’s detachment from the US Dollar should serve as a reminder that ultimately,  stablecoins are only as stable as their foundations. 

Written by Rob Henderson for Novum Insights

*The information provided in this article by Novum Insights is for informational purposes only, we make no warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability or availability with respect to the article or the information, products, services, or related graphics contained on the website for any purpose. Any reliance you place on such information is therefore strictly at your own risk. None of the information provided is intended nor should be relied upon for the purposes of investment.