Cryptocurrency Update: Terra and Stablecoins


May 13, 2022.  By Kevin Donohue:

With the recent news about the stablecoin TerraUST selling off, there is a potential for further losses in Bitcoin and the cryptocurrency market as a whole. While it is difficult to concisely summarize the recent events in the cryptocurrency markets, we think it is important to provide some context into TerraUSD and stablecoin headlines:

What is TerraUSD?  

TerraUSD (UST) is an algorithmic stablecoin created by South Korean crypto developer Do Kwon and his company Terraform Labs. The coin was created with the goal of tracking the US Dollar 1 for 1, often referenced in headlines as “pegging” to the dollar. At the time of this writing, UST has plunged more than 50% intraday 5/13/22. This drop in value could have major implications for Bitcoin in the very near future.


What are Stablecoins?

In short, they are digital assets, referred to as coins, designed to keep (store) their value. Many investors use them as deregulated bank accounts in the crypto economy.

The biggest attraction to stablecoins is the ability to send currency across country borders without having to open foreign bank accounts. Instead, investors anywhere in the world can simply use a digital crypto wallet that provides the ability to receive and send stablecoins to anyone in the world.

There are coins that are pegged to other assets, such as fiat currencies or physical commodities, and the issuers of the coin back up the value by holding on to the pegged asset. For example, with a fiat currency stablecoin pegged to USD, for every $1 of the coin sold the issuer of said stablecoin promises to issue $1 of USD back to the investor upon redemption.

It is important to acknowledge that not all stablecoins are pegged to traditional currencies. Some are pegged to other cryptocurrencies, or collections of cryptocurrencies, which have much greater volatility than traditional currencies.  Even more complex in nature, there are stablecoins that are pegged to algorithms (a.k.a. algorithmic stablecoins) that aim to manage supply and demand of the coin to keep the price stable. The main difference, and concern, with these is that there is no reserve backing the coin. Instead, the coin is backed by investor confidence in cryptocurrencies and the algorithm alone.


How does TerraUSD, an algorithmic stablecoin, work?

The algorithm uses the supply and demand of UST and its sister coin, the Luna token (issued by the Luna Foundation Guard), to maintain it’s $1 price (peg). In a normal market, with little price volatility, when an investor wants to deploy money into TerraUSD, a new UST coin is minted (created) and a Luna token for the price of $1 is burned (redeemed).

When the price of UST begins to drop below $1, the algorithm relies on investors to take advantage of the price arbitrage and burn UST coins, thereby removing them from circulation, and receive Luna tokens at a discounted rate.  It is very similar to a currency swap whereby the investor can burn the USD value of $0.99 worth of UST and will receive the USD value of $1 of Luna Token. In this process, there is now less UST in circulation and theoretically the price for UST should begin to climb back to $1. This is of course an ideal situation in the cryptocurrency world, relying on efficient markets with little volatility, and assuming the laws of supply and demand are in perfect working order.


What is The Luna Foundation Guard (LFG)?

LFG is a non-profit organization dedicated to supporting the Terra ecosystem and improving the sustainability and stability of UST. Essentially the foundation was created to act as a reserve for UST redemptions during selloffs of the coin.

In February 2022, LFG raised $1 billion in an OTC sale of Luna tokens to several crypto based investment firms, including Three Arrows Capital and Jump Crypto. With one of the largest raises in the history of the crypto sector, LFG used the proceeds to establish a Bitcoin reserve for UST.


TerraUSD price drop and the effect on Bitcoin – Notes and Concerns:

  • The issue with this supply and demand algorithm is that it relies solely on investor confidence and assumes normal market conditions. During periods of high volatility, to the buy or sell side, the supply/demand algorithm may not be strong enough to stabilize the price.
  • Last weekend hundreds of millions of UST sold on Anchor, UST’s top lending platform, as well as on other platforms such as Curve and Binance. Because of the substantial number of redemptions, the supply/demand algorithm was not able to keep up the Luna token creation; as such, the price for UST fell below $1 and was not able to stabilize.
  • The mass selloffs of UST continued following that weekend, leading Binance to halt the trading of UST for a brief time, and the price of UST fell to around $0.61.
  • In an effort to stabilize the price of UST, Luna Foundation Guard loaned roughly $750 million worth of Bitcoin to third party trading firms to raise capital to support the price of UST. At the time of this writing, the third-party investment firms have not sold off any of the loaned Bitcoin.
  • Crypto investors are closely watching the price of UST to see if it can return to its stable price of $1. If UST does not stabilize, LFG will need to sell some of its Bitcoin to raise capital in order to fund UST. Perhaps more detrimental, though, will be the impact on investor confidence.

Why this is important to the price of Bitcoin and the crypto economy?

This effort to stabilize UST could lead to a substantial drop in crypto investor confidence (the theoretical backing of UST), and investors could begin to liquidate their holdings causing the price of Bitcoin to drop significantly. Retail and institutional investors (including the third-party firms holding the loaned Bitcoin) alike might possibly join in on the “Bank Run” and Bitcoin could fall drastically. 

We understand that alternative investments can hold an important place in the allocation of certain portfolios. That said, cryptocurrencies carry significant risks and are not recommended for the average investor.  Before making any investment, it is critical to understand the risks involved and how it fits within your overall investment objective.  Please let us know if you have any questions or would like to discuss further.