What is terraUSD (UST) and how does it affect bitcoin?
Pedestrians walk past a Bitcoin cryptocurrency exhibit on February 15, 2022 in Hong Kong, China.
Anthony Kuan | Getty Images
A multi-billion dollar bet that bitcoin can act as a “reserve currency” for the crypto-economy is already being tested as controversial stablecoin UST struggles to maintain its peg at $1.
UST fell nearly 99 cents over the weekend, fueling fears of a potential “bank run” that could force Terra, the project behind it, to dip into a $3.5 billion pile of bitcoins to back the token.
Now, the Luna Foundation Guard, an organization created by the inventor of Terra, announces that it will lend $750 million in bitcoins to trading companies to keep UST price pegged. But that did little to allay investor concerns about the implications for bitcoin.
What is the UST?
Developed by Singapore-based Terraform Labs, UST is what is known as an algorithmic stablecoin. It aims to perform the function of stablecoins like tether, which track the price of the US dollar, but without any actual cash held in reserve to back it up.
Instead, UST – or “terraUSD” – is created by destroying a sister token, known as luna, using smart contracts, lines of code written in the blockchain.
“If you have, say, $405 and you burn a luna, you should be able to mint 405 from the UST stablecoin,” says University of Sussex finance professor Carol Alexander.
The same applies vice versa – new luna is created by burning UST and other algorithmic stablecoins supported by Terra.
Terra’s protocols also feature an arbitration mechanism, where investors can exploit deviant prices for each of the tokens. For example, too much demand for UST can cause its price to rise above $1. This means that traders can convert $1 from luna to UST and pocket the difference as profit.
The model is designed to balance the supply and demand of UST. When the price of UST is too high, users are incentivized to burn luna and create new USTs, thereby increasing the supply of stablecoins while decreasing the amount of luna in circulation.
“The moon becomes rarer, which makes it more valuable, transferring that value into the UST,” says Alexander.
When the price of the UST is too low, the reverse happens – the UST is burned and the luna is hit. This should, in theory, help stabilize prices.
“This assumes normal market conditions,” said David Moreno Darocas, research analyst at CryptoCompare.
“During periods of high volatility and one-sided buying/selling activity for the UST, the stabilizer above may not be sufficient to maintain the near-term peg.”
There have been several instances where the UST has decoupled from its $1 peg, raising concerns about the viability of its business model – especially in a situation where multiple people are trying to redeem their tokens at the time.
The final challenge arrived this weekend. Hundreds of millions of USTs have been sold on Anchor, Terra’s flagship lending platform, as well as Curve and Binance, prompting accusations of a “coordinated attack” on the stablecoin.
“Men will literally attack an unsuccessful stablecoin instead of going to therapy,” said Do Kwon, the South Korean crypto entrepreneur who co-founded Terraform Labs, in a since-deleted tweet.
To address concerns about the sustainability of his stablecoin, Kwon plans to buy up to $10 billion worth of bitcoins through a nonprofit organization called Luna Foundation Guard. These funds would provide a safety net in the event of a dramatic drop in the value of UST.
The idea is that bitcoin would act as the “reserve currency” for the Terra ecosystem.
LFG purchased an additional $1.5 billion in bitcoin last week, bringing its total reserves to around $3.5 billion. However, on Monday the organization said it was taking steps to “proactively defend the stability” of the UST.
This includes lending $750 million worth of bitcoin to trading companies to “protect the peg of UST” and another 750 million loaning UST to buy more bitcoin “as market conditions normalize.” .
“In the case of most of these stablecoin algos, we have seen that the teams behind the project usually have to step in – so they are not yet fully decentralized or independently managed,” said Vijay Ayyar, Head of Development at corporate and international at crypto. Luno exchange.
What this means for bitcoin
Investors fear that bitcoin’s underpinning of the UST will bring additional pain for the cryptocurrency.
The world’s largest digital coin fell below $33,000 on Monday, falling to its lowest level since July 2021. It was last trading at around $32,921, down 6% in the past 24 hours.
LFG’s intervention will “add to the selling pressure,” said Derek Lim, head of crypto news at the Bybit exchange. “BTC will likely drop before bouncing back as short sellers take profits.”
Kwon insisted that LFG is “not trying to get out of its bitcoin position.”
“As the markets recover, we plan to repay the loan to ourselves in BTC, thereby increasing the size of our total reserves,” he said.
The plan is to eventually allow UST holders to trade their tokens in exchange for bitcoins. Bitcoin would play the role normally played by luna in a crisis scenario, with arbitrageurs buying UST and then swapping it for discounted bitcoin. But that’s still weeks away from being implemented, and it’s unclear how it would work in practice.
The biggest risk going forward would be another UST unpeg forcing LFG to liquidate its bitcoin holdings, said Hendo Verbeek, head of quantitative trading operations at Faculty Group. This, in turn, could lead to further liquidations of “over-indebted” buyers, according to Verbeek.
“It’s a nightmare scenario that looks like a real outcome of events,” he said.