TerraUSD Crash Shows Risks of Algorithmic Stablecoins

While TerraUSD (UST) stablecoin holders planned for their currency holdings always to be worth one dollar, a recent massive drop in the value of the cryptocurrency markets have led to a severe decline in value, touching a low of $0.30 on May 11, 2022. Here's a look at what happened, why this stablecoin was able to drop below its target value, and what investors can learn from the crash of Terra (LUNA) and TerraUSD.

What is TerraUSD?

TerraUSD is a stablecoin operating on the Terra blockchain. TerraUSD, which trades with the symbol UST, is always intended to be worth exactly one dollar, enabling transactions to process with predictable results and giving cryptocurrency investors and traders an option to store their assets in cryptocurrency without the risk and volatility associated with typical digital currencies.

However, sparked by a drop in overall cryptocurrency values, the UST stablecoin plunged in value beginning May 9, 2022. According to CoinGecko, the currency hit a low value of $0.298 on May 11. This is the opposite of what was supposed to happen. So why did TerraUSD fall? It was driven by the underlying assets that were supposed to give UST a stable price.

Why Did UST Fall Below One Dollar?

Stablecoins are digital assets intended to retain a fixed value compared to an underlying asset or currency. The most common stablecoins track the United States dollar, although there are stablecoins for other international currencies, including the euro, and stablecoins that track the value of gold.

Every stablecoin works differently and is managed by a different group or organization. In the case of TerraUSD, the currency is a part of the Terra ecosystem, which also operates the Terra (LUNA).

The TerraUSD currency is not backed by U.S. dollar-denominated assets. Instead, a computer algorithm creates (mints) and destroys (burns) both UST and LUNA to bring the price back into equilibrium. This worked reasonably well in practice from the inception of Terra and Luna until the recent market plunge, when the downward pressure on TerraUSD was too much for the algorithm to keep up.

The Risks of Algorithmic Stablecoins

When the United States began printing dollars, it maintained a stock of gold and silver intended to support the dollar's value. If someone wanted to bring a silver certificate or gold certificate to the government and turn it in for silver or gold, they were able to until 1964, when the dollar moved to be backed by the "full faith and credit of the United States government."

Several stablecoins use similar systems and maintain reserves in dollar-denominated assets to support the value of their currencies. However, that’s not the case with algorithmic currencies like TerraUSD. Because it’s only backed by the community that uses the currency and computer algorithms designed to keep the market demand for the currency balanced at one dollar, there’s no guarantee that the currency can maintain its peg.

In the case of Terra, the situation became so dire that the Terra validators halted new transactions on the morning of May 12, 2022.

The Bottom Line

The Terra Luna and TerraUSD currencies experienced a significant crash in market value, and no one knows when they will recover. This highlights the risk of certain cryptocurrencies and algorithmic stablecoins. While Terra may turn the corner and recover, this situation is a stark reminder of why it's important to invest carefully and understand the risks when making any new investments.