Introduction to Terra
Market Meditations | March 1, 2022
Increasingly, we see people losing faith in traditional monetary systems.
This has only been heightened by the current Ukraine-Russia conflict where we are seeing an upsurge in demand for stablecoins. According to data from The Block, total Stablecoin supply is currently at $180 billion. Terra’s UST stablecoin in particular has shown considerable strength. In this feature’s ‘Big Idea’, we explore stablecoins and their appeal.
Stablecoins are cryptocurrencies that attempt to peg their market value to some external reference, most commonly the US dollar. They aim to offer the convenience, privacy and security of crypto whilst offering the price stability of fiat.
How Do Stablecoins Keep Their Peg?
- Fiat-backed such as USDC or USDT: these coins are backed 1:1 by real-world fiat currency stored in a reserve.
- Crypto-backed such as DAI: these coins use other cryptocurrencies as collateral to maintain a stable value. To provide a buffer against price volatility, crypto-backed stablecoins are over-collateralized.
- Algorithmic such as UST: these coins do not require fiat reserves or cryptocurrency as collateral. Instead, they utilize complex algorithms to manage the coin’s supply.
More on Algorithmic Stablecoins
Algorithmic stable coins are decentralized and often associated with some sort of Decentralized Autonomous Organization (DAO) unlike USDT or USDC which are controlled by a centralized authority.
Terra’s native UST coin is a great example as it has recently become the largest decentralized stable coin with a current market cap of $12.8 billion.
- UST is not backed by dollars, its peg is maintained by allowing users to adjust the supply of UST and LUNA via a mint and burn mechanic.
- When the price of UST is less than $1, users are incentivised to exchange their LUNA in exchange for a small profit.
- The protocol burns one UST and mints LUNA, reducing the supply of UST to increase the price.
- When the price of UST is greater than $1, users can swap $1 worth of LUNA for 1 UST again making a small profit on the difference. The protocol burns LUNA and mints UST which increases the supply of UST thus decreasing the price to the 1:1 peg.
A key concern of algorithmic stablecoins is the risk of a ‘death spiral’ which could occur in bearish market conditions. To combat this, the Luna Foundation Guard (LFG) raised $1 billion in a private token sale which will be used to create a bitcoin-denominated reserve to protect the 1:1 peg of UST. Meaning that in bearish conditions, participants have the option to swap UST to BTC. This will reduce the impact of minting more LUNA which could suppress price further.
Twitter handle @WestieCapital explains the importance of this for Terra’s long term stability in a thread here.
Stablecoins are crucial to the infrastructure of the crypto markets as they allow participants to benefit from the price stability that fiat currency provides. Analysts believe stablecoins such as UST may continue to grow in adoption, use cases and value.