We’ve been talking about Terra (LUNA) and its stablecoin, UST, a lot in recent weeks. Terra’s founder Do Kwon has been on the war path, publicly picking battles with the DAI stablecoin, and making a stated goal of killing DAI. This week Terra’s UST has raised in market cap to be the #3 largest stablecoin in crypto–and the largest algorithmic stablecoin.
While the stablecoin wars are in full swing, UST has been clearly winning. In the past few months, UST has passed the DAI and Binance USD (BUSD) stablecoins, both touting billions in market cap.
What is an algorithmic stablecoin, and why does it matter?
Generally, stablecoins are pegged to the US dollar, keeping a value of $1 perpetually with very minimal variation (unless something goes horribly wrong). Typical stablecoins keep this peg by holding a large amount of non-volatile assets, like US dollars or US government bonds. These assets fall into a category referred to as “cash or cash equivalents.”
Since these assets are held and managed by a single party, the makers of the stablecoin, these are considered to be very centralized. There have even been cases where the top two stablecoins, USDC run by Circle and USDT run by Tether, have used that centralized power to freeze stolen assets.
This is where algorithmic stablecoins come into play. Unlike centralized stablecoins, which have their peg managed by an organization guiding the treasury, algorithmic stablecoins have their peg maintained by an algorithm. This means they are generally more decentralized, and cannot have assets seized by the managing organization.
The Terra Algorithm
There have been a wide range of algorithms, but Terra’s is becoming increasingly popular. Terra’s algorithm is very simple: you can convert $1 worth of LUNA for 1 UST at any point, and vice versa. This means that if UST starts to depeg, and becomes worth $0.98 per UST instead of $1, you can trade one UST (worth $0.98) for $1 of LUNA and make 2% instantly. In the other direction, if UST goes up to $1.02 for one UST, you can trade $1 of LUNA for 1 UST worth $1.02.
This interaction is done by burning and minting both the LUNA and UST tokens. When you sell LUNA for UST, you’re destroying those LUNA tokens and creating new UST tokens. That means the market cap is not determined by the amount of assets in a bank account like in the case of USDC and USDT, but instead by the active demand for UST tokens.
This also means that the LUNA supply decreases as the UST demand increases, resulting in higher LUNA prices.
While the UST stablecoin has a market cap of $17B, the future isn’t so clear. Do Kwon has announced that they are buying up $10B in other crypto assets to back up UST and LUNA. This move may help prevent issues that other algorithmic stablecoins have had in the past, effectively providing a price floor for the assets, but it does seem to make the assets more coupled to the prices of other crypto assets. DAI is also stepping into this uncharted territory, but it’s unclear how much of the decentralization removes.