How TerraUSD lost its peg: algorithmic stablecoin trouble

How TerraUSD lost its peg: algorithmic stablecoin trouble

Volatility periods have always been difficult for decentralized stablecoins, and now TerraUSD experiences a trouble of its own, and a pretty big one.

On Saturday, a whale sold $285M of TerraUSD, which led to it briefly losing its peg and falling to $0.98. $LUNA, the currency that fuels Terra blockchain and helps maintain TerraUSD peg, lost 10%.

Nothing catastrophic in itself, but in the current capitulation market any sign of weakness has exaggerated consequences, and yesterday showed just how much.

? $LUNA has lost over 50%, and TerraUSD has once again de-pegged from the dollar, falling as low as $0.67. It has since risen to $0.92, but the situation is still dire: $LUNA market cap of $11Bn is now much lower than TerraUSD market cap of $16.5Bn, which means that its value is not properly backed.

? Luna Foundation Guard, an organization tasked with managing the network’s reserves, has deployed an emergency safeguarding measure already on Monday, loaning out $750M worth of Bitcoin to OTC firms to try and save the peg by intervening on the market. It has yielded modest results so far, and yesterday Terra’s creator Do Kwon reported deploying more capital, moving 42’500 BTC to various accounts.

⚖️ Unlike DAI, the first algorithmic stablecoin that uses over-collateralization, TerraUSD maintains the dollar peg via an elastic money supply (contracting and expanding when price deviates from the peg), enabled by stable mining incentives (miners absorb supply contraction costs in the short term and are compensated with increased rewards in the mid to long term). Big market movements, however, can destabilize this system – and they did.

Terra creators must have considered this possibility: in the end of March Luna Foundation announced its intentions to buy $10Bn worth of Bitcoin and has so far accumulated $3.5Bn of it. However, the price of Bitcoin itself losing 25% in the last 5 days decreased the dollar value of the reserve, and selling BTC on the market to maintain the peg could have contributed to Bitcoin’s fall.

Financial markets always move together, because its products are extremely dependent on each other. Crypto markets are not much different in this aspect, especially such complex assets like an algorithmic stablecoin maintained by a blockchain’s native currency LUNA and backed by Bitcoin.

It is now imperative for Terra to find a solution to return TerraUSD to $1, otherwise it would be near-impossible to regain the market’s trust.