Last Updated on May 13, 2022
Stablecoins are pegged to fiat currencies like the US dollar. In the cases of USD-pegged stablecoins, their prices are supposed to be $1 at all times. Aiming to provide refuge to those who want to exit constant volatility, while still staying in the crypto market.
Each stablecoin project differs in ways they maintain the peg. Supported by fiat reserves, meaning they have cash or cash-equivalent assets in their reserves. So each UST or USDC traded in the crypto market is backed by what’s actually in the possession of the stablecoin issuer.
The “algorithmic” naming convention comes from the on-chain algorithm that facilitates a change in supply and demand between the stablecoin and another cryptocurrency that props them up.
Algorithmic stablecoins are typically undercollateralized – they don’t have independent assets in reserves to back the value of their stablecoins.
In the case of the recent turmoil of Terra LUNA and UST, the algorithm is supposed to work like this:
“When UST supply is too small and demand for it is too high, the price of UST goes above $1. To bring UST back to its peg, the Terra protocol lets users trade 1 USD of LUNA for 1 UST at the Terra station portal. This trade burns 1 USD of LUNA and mints 1 UST, which users can sell for 1.01 USD and pocket a profit of 1 cent. It doesn’t sound like a lot, but these profits add up when done in large quantities.”
Needless to say, it failed to keep up with the extreme conditions, the algorithm couldn’t facilitate the minting of new LUNAs at a speed needed to re-peg UST.
Defending UST means sacrificing LUNA’s price since it increases LUNA’s supply, and greater supply means selling pressure on a token’s price. As a result, LUNA violently crashed during the night of May 11, falling more than 97% to as low as $0.88.