What Is a Stablecoin and Currency Pegging?
TerraUSD, abbreviated as UST, is a stablecoin, a type of cryptocurrency designed to maintain a steady value pegged to some stable currencies, like a national currency such as US dollars etc. A currency peg is a policy in which a cryptocurrency sets a specific fixed exchange rate with a commonly used currency such as US dollars. A good currency peg can help reduce uncertainty make the currency more trustworthy. Nowadays, most popular stablecoins on the market, such as USDT and USDC are pegged one-to-one to the U.S. dollar. Stablecoins play an important role in the crypto economy which can bring more liquidity to the market. The traders can use those stablecoins as the an anchor to the US dollars without the need to worry about the exchange rate. The TerraUSD, the third-largest stablecoin, is developed by Terraform Labs and is also pegged to the US dollars. To maintain the peg with the fiat currencies like US dollars, each stablecoin project has a differenct way to maintain the peg. For example, USDT and USDC projects are using cash or cash-equivalent assets in their reserves to keep the one-to-one pegging to the US dollars. Some stablecoins like DAI is backed by their ETH deposited into its smart contracts.
How TerraUSD (UST) Stablecoin Works?
In comparison, TerraUSD, the third-largest stablecoin, is using the algothrim instead of the real or digital assets to keep the pegging. UST is an algorithmic stablecoin which means its pegging to US dollar is maintained by the computers codes instead of the real or digital assets. UST is connected to its native token LUNA. The code working in the background is responsible for burning or minting LUNA/UST to maintain the price of these tokens. When one UST is minted, $1 of Luna will be burned, and it also works on the other way around for Luna minting and UST burning. When the UST price is going below its peg value $1, say 1UST = $0.98, then more LUNA will be minted in order to burn UST and decrease its supply. The increased supply of luna will dilute its price and make it decrease. Conversely, when the UST price is over its peg value $1, Luna coins will be burned and more UST will be minted to increase its supply to let its price go down.
How Did the LUNA and UST Crash Happen?
In most of the time, this process will help maintain its price equilibrium between the UST and Luna pair. However, suddenly, a large amount of UST is dumped to the market, the stablecoin will start to depeg below $1, then the algorithm will mint more LUNA tokens and burn UST in order to peg UST back to $1. When the UST value is further away from $1, more LUNA tokens will be minted by the algorithm. The more LUNA tokens are minted, the lower the price it will be. The lower price of the token will causes more tokens to be created to burn UST to defend its peg value $1. This process will create a waterfall effect and trigger a massive selling cascade as the algorithm can trade in a circle, which will make it worse and worse by creating trillions of tokens in a short time. Eventually, it results in LUNA's price being ZERO. As of May 13, there was 6.5 trillion Luna tokens created. Although the Luna Foundation Guard had been purchasing bitcoins to save UST from depegging. However, it didn't work at all. So far, there are still no official announcements about the resolution about how to deal with the huge amount of tokens. A Luna burn of its supply or a potential Luna fork may be the possible choices of the Luna team.
