TerraUSD Crash Shows Risks of Algorithmic Stablecoins

While TerraUSD (UST) stablecoin holders planned for their currency holdings always to be worth one dollar, a recent massive drop in the value of the cryptocurrency markets have led to a severe decline in value, touching a low of $0.30 on May 11, 2022. Here's a look at what happened, why this stablecoin was able to drop below its target value, and what investors can learn from the crash of Terra (LUNA) and TerraUSD.

Key Takeaways

  • While intended to be worth exactly one dollar, the TerraUSD (UST) stablecoin fell to a low value of $0.30 on May 11, 2022.
  • As an algorithmic stablecoin backed by cryptocurrencies, a recent downturn in cryptocurrency prices caused a fall in UST prices.
  • The situation for Terra (LUNA), a related currency, became so dire that Terra halted processing new transactions on May 12, 2022.

What is TerraUSD?

TerraUSD is a stablecoin operating on the Terra blockchain. TerraUSD, which trades with the symbol UST, is always intended to be worth exactly one dollar, enabling transactions to process with predictable results and giving cryptocurrency investors and traders an option to store their assets in cryptocurrency without the risk and volatility associated with typical digital currencies.

However, sparked by a drop in overall cryptocurrency values, the UST stablecoin plunged in value beginning May 9, 2022. According to CoinGecko, the currency hit a low value of $0.298 on May 11. This is the opposite of what was supposed to happen. So why did TerraUSD fall? It was driven by the underlying assets that were supposed to give UST a stable price.

Why Did UST Fall Below One Dollar?

Stablecoins are digital assets intended to retain a fixed value compared to an underlying asset or currency. The most common stablecoins track the United States dollar, although there are stablecoins for other international currencies, including the euro, and stablecoins that track the value of gold.

Every stablecoin works differently and is managed by a different group or organization. In the case of TerraUSD, the currency is a part of the Terra ecosystem, which also operates the Terra (LUNA).

The TerraUSD currency is not backed by U.S. dollar-denominated assets. Instead, a computer algorithm creates (mints) and destroys (burns) both UST and LUNA to bring the price back into equilibrium. This worked reasonably well in practice from the inception of Terra and Luna until the recent market plunge, when the downward pressure on TerraUSD was too much for the algorithm to keep up.

The Risks of Algorithmic Stablecoins

When the United States began printing dollars, it maintained a stock of gold and silver intended to support the dollar's value. If someone wanted to bring a silver certificate or gold certificate to the government and turn it in for silver or gold, they were able to until 1964, when the dollar moved to be backed by the "full faith and credit of the United States government."

Several stablecoins use similar systems and maintain reserves in dollar-denominated assets to support the value of their currencies. However, that’s not the case with algorithmic currencies like TerraUSD. Because it’s only backed by the community that uses the currency and computer algorithms designed to keep the market demand for the currency balanced at one dollar, there’s no guarantee that the currency can maintain its peg.

In the case of Terra, the situation became so dire that the Terra validators halted new transactions on the morning of May 12, 2022.

The Bottom Line

The Terra Luna and TerraUSD currencies experienced a significant crash in market value, and no one knows when they will recover. This highlights the risk of certain cryptocurrencies and algorithmic stablecoins. While Terra may turn the corner and recover, this situation is a stark reminder of why it's important to invest carefully and understand the risks when making any new investments.

Are Stablecoins Like USD Coin and Gemini Dollar at Risk?

USD Coin and Gemini Dollar are stablecoins related to the Coinbase and Gemini exchanges, respectively. Each maintains accounts with dollar-denominated assets at least equal to the number of stablecoins in circulation. Outside accounting firms audit these currencies regularly and release reports on asset values. Despite these differences with TerraUSD, there is no guarantee that these coins will maintain their value, and they are not FDIC insured.

What Is a Blockchain?

A blockchain is a distributed software database, often referred to as a distributed ledger. Blockchains are maintained by a network of computers around the world. Blockchain software is critical in the operation of cryptocurrencies.

How Much Did People Lose When TerraUSD Crashed?

Before the value plunged, the total market value of all TerraUSD currency was a little over $18.5 billion. As of this writing, the total market capitalization of TerraUSD was just over $4.5 billion, indicating a market decline of approximately $14 billion.

Article Sources
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  1. CoinGecko. "TerraUSD (UST)."

  2. Terra. "About the Terra Protocol."

  3. Twitter. "Terra (UST) Powered by LUNA."

  4. CoinMarketCap. "TerraUSD to USD Chart."

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