Crypto market crash — How an algorithmic stablecoin differs from traditional stablecoins

• The crashing value of Terra’s UST stablecoin has called the future of algorithmic stablecoins into question.
• Instead of being backed by dollars or dollar equivalents, algorithmic stablecoins are backed by another crypto asset.
• In Terra’s case, UST was backed by LUNA, creating a codependency which led to the eventual collapse of UST’s stability.

Terra’s UST stablecoin continues to remain below its $1 target after dipping by more than 90% in 24 hours on May 11. Meanwhile, Terra’s native LUNA token has lost most of its overall value.

Investor sentiment is geared towards fear and consumer confidence is being tested with other stablecoins like Neutrino, FRAX, Celo Dollar and sUSD feeling market pressure.

Stablecoins have done a lot of good, especially in emerging markets where people don't have access to the dollar and their own currency is volatile. However, with currency, you want to have some stability day to day — the golden rule that UST violated as its price went crashing yesterday.

Caption: Price movement of Terra’s UST stablecoin over the past seven days

Source: CoinMarketCap

Many believe Terra’s founder Do Kwon should have seen this coming, especially since he was warned by experts on his ‘algorithmic’ approach. Most traditional stablecoins, like Tether and Circle, are backed by actual reserves — dollars or dollar equivalents. Algorithmic stablecoins like Terra, however, don’t need 1:1 backing.

What is an algorithmic stablecoin?

Instead of being backed by dollars or dollar equivalents, algorithmic stablecoins are backed by another crypto asset instead. In Terra’s case, it’s the LUNA token.

In order to mint 100 UST, a person needs to burn $100 worth of LUNA, which has a floating value. In order to mint $100 worth of LUNA, you must destroy 100 UST. Everytime UST is minted, an equivalent value of LUNA is burnt to keep the peg roughly at $1.

In order to maintain its dollar peg, the algorithm — a well defined set of instructions like the minting ratio — encourages investors to take advantage of price changes between UST and its sister token LUNA. As a result, UST relies heavily on LUNA. Investors are motivated to burn UST, in order to gain LUNA.

While algorithms are automated, there are people behind the algorithm. And, there’s also manipulation. Attackers put in the efforts to buy $1 billion in USD, billions in Bitcoin, triggering FUD and then triggering a sell-off.

Many have called the UST’s fall from grace the ‘2008 global financial crisis’ of the crypto world. And, the crisis has also called into question the future of other algorithmic stablecoins as well as sparked debate around the question of true decentralisation.

According to Kwon, Terra is looking for "exogenous capital" in combination with implementing protocol changes to help it get back on track.

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