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TerraUSD, Algorithmic Stable Coins, and the Risks

Monday, May 02, 2022 09:37 AM | Nick Dey
TerraUSD, Algorithmic Stable Coins, and the Risks

TerraUSD (UST) is a stablecoin but has been surprisingly volatile. The Terra Ecosystem, which can be thought of as similar to the Ethereum ecosystem, is powered by two tokens: Luna and UST. The supposedly stable UST is backed by a dollar equivalent of Luna, which fluctuates.

To buy UST, you mint some by trading the equivalent dollar amount Luna for Terra. That means a new UST coin has entered circulation and the price has marginally dropped. To fix this, Terra burns the Luna that it receives in order to increase the price of Luna enough to offset the change in price from minting a new UST.

The reverse works as well. You can mint new Luna by trading in UST, with the UST now getting burned instead.

While minting a new UST or LUNA, the algorithm pretty simply rebalances things to keep a near-constant price. But the price of LUNA is constantly changing and isn’t backed by anything except anticipation that one day, the Terra Ecosystem will house many dApps that spur higher demand for LUNA.

As long as interest in LUNA remains, the company will be able to encourage arbitrage traders to rebalance their price as needed, as they make a pretty safe profit.

When the price of UST dips below $1, Terra raises UST’s price by selling people $1 worth of LUNA for a UST coin. So if the price was $0.95, you could make a “guaranteed” profit of $0.05 in LUNA.

But if LUNA crashes, or remains in a steady decline for too long, the arbitrage traders might not be incentivized to make these necessary trades until UST dips further and further lower.

If I can’t trust that I will get this LUNA and be able to turn around and sell it quickly for $1, then I’ll have to wait until I get a bigger buffer. UST’s current 5-day range is $0.9982-$1, meaning arbitrageurs are willing to trust that anytime it dips any amount below $1, they will make a marginal profit.

The more volatile LUNA is, the more UST has to fall in order to incentivize rebalancing. Falling to $0.999 (UST’s low) is for the most part negligible to the stablecoin’s holders. Especially since it tends to snap back to $1 pretty quickly.

But herein lies the problem with algorithmic stablecoins, they attempt to create stability out of another coin’s inherent instability, out of a coin that has no intrinsic value except to be constantly rebalanced in order to keep the other coin’s price stable. Currently, UST benefits from there being a lot of attention and hype around the Terra ecosystem.

There are two reasons to hold LUNA: you think the Terra Ecosystem will grow, or you want to do something on the Terra Ecosystem. More than likely, at this point, it would have to be the first one.

As long as things are bullish, there is no worry. But if people lose interest, LUNA holders get stuck with the bill since Terra has to offer more and more LUNA to incentivize a rebalance of UST.

Ryan Clements, author of Built to Fail and assistant professor of Business Law at the University of Calgary has said algorithmic stablecoins are fundamentally flawed because they rely on these three factors.

1.“Support level of demand for operational stability.”

2. “Independent actors with market incentives to perform price-stabilizing arbitrage.”

3. “They require reliable price information at all times.”

As Clements notes, “At some point you look at the one with no intrinsic value and you think, why is this worth $5?”

And, if at some point the arbitrageurs ever start to wonder the same, UST could crash and leave the stablecoin’s investors wishing they’d gone with a dollar-backed stablecoin.

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