If you have been active on crypto Twitter and Reddit communities, you’d have seen several posts linking the recent Bitcoin dip to LUNA and UST. However, the explanations may have caused you more confusion than clarity. Not to worry, this article will provide you with a detailed breakdown, explaining like you’re five.

What is Terra USD (UST)?

Terra USD is an algorithmic stablecoin created by Terra Blockchain founders Daniel Shin and Do Kwon. Stablecoins are designed for price stability, such that regardless of market volatility, they can maintain a stable price. Many stablecoins are valuated in the US dollar, and it is expected that they maintain their prices to $1 amid any price surge/dip.

There are several types of stablecoins. However, our focus, algorithmic stablecoins, is designed to automatically adjust their supply to counterbalance prices’ up/down movement in the crypto ecosystem. Terra USD is one such algorithmic stablecoin; its tokenomic mechanism is designed to mint 1 UST by burning $1 equivalent of LUNA (Terra’s governance token).

How Does This Work?

LUNA's supply deflates by burning $1 of LUNA to mint UST, and with steady demand, LUNA’s price will increase. For a more precise understanding, let’s use an example with numbers.

Assuming LUNA is $50 and 1 UST is to be minted, 1/50 (0.02) LUNA will be burnt. Since LUNA is burnt and the market maintains its level of demand, there is less LUNA for the market to purchase, so LUNA’s price will go up.

LUNA will maintain an upward movement in a very healthy market because there is a lesser LUNA supply to fulfill the demand. As a result, LUNA can go as high as $100, and the amount needed to mint one UST will be 1/100 (0.01) LUNA.

Where did LUNA fail?

UST has been largely successful, and the model appeared to be near perfect until recently when financial markets began to experience a huge dip.

Usually, when the crypto market experiences a dip, investors and holders sell their tokens for stablecoins; hence, the demand for stablecoins is a lot heavy during dips. But unfortunately, the crypto ecosystem has been experiencing a downward movement since Bitcoin’s all-time high in November; as a result, demand has drastically dwindled.

Luna’s algorithm did not sufficiently account for high volatility periods of sustained selling pressure; this eventuality has led to the failure of both LUNA and UST.

What Happened Over the Weekend?

Extreme levels of reduced demand have caused the LUNA/UST tokenomic model to fail. There is a massive demand for UST, while there is little for LUNA. As a result, $1 of LUNA is still required to mint 1 UST, but LUNA’s price keeps falling since demand is inexistent.

Worse still, over the weekend, hundreds of millions of UST were sold on several exchanges, causing the price to drop as low as $0.67, 33% lower than the supposed value of a stablecoin. Do Kwon, the co-founder of Terra, regarded this as a coordinated attack on the stablecoin. To regain UST’s dollar peg, millions of UST must be minted, and consequently, many LUNA must be burnt. Hence, LUNA has poorly dipped, dropping from over $80 on Friday to $32 at the end of Monday and $0.26 at the time of press on Thursday.

Since LUNA is steadily burnt to mint more UST and maintain the peg, LUNA keeps falling in the absence of demand and even fell below UST in terms of market capitalization.

How Does This Affect Bitcoin?

Does Kwon have a Bitcoin reserve with the purpose of helping to stabilize the Terra Ecosystem currencies (LUNA and UST)? This is similar to our traditional financial systems, where central banks keep large sums of money in foreign reserves to stimulate the economy.

As a result, in the early hours of Monday, the Luna Foundation Guard (LFG) announced that they would take out about 42,500 BTC ($1.5billion) from the reserves. $750m will serve as loans to OTC trading firms to help stabilize the UST peg from outside the algorithm, and $750m will serve as additional buyback funds when market conditions stabilize.

This massive volume of BTC sales has caused FUD in the market by people claiming that Terra is a Ponzi scheme and Do Kwon is trying to liquidate the reserves. Hence, BTC has further fallen, thus affecting the entire crypto ecosystem. However, Do Kwon has announced that LFG isn’t trying to exit their BTC position but only loaning out the reserves for traders to manually hold the UST peg.

What is The Takeaway?

Many questions have arisen as to the sustainability of Algorithmic stablecoins.

• Can algorithmic stablecoins be fully decentralized without external intervention?
• Is the problem with Terra, or is there a potential problem with all algorithmic stablecoins?
• Are algorithmic stablecoins indeed the future, or are we better of with fiat and commodity-backed stablecoins like USDT and USDC?

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