The Problem With Algorithmic Stablecoins (Part One)

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2 years ago

When the stablecoin USDT came into the crypto world, it was welcomed by almost all and sundry. A stablecoin is a token that has a fixed price usually $1 at all times. These tokens do not fluctuate in price and are usually back by some asset in a 1:1 ratio. For example, USDT is a token that's supposedly back by the dollar. What this means is that for every single USDT minted, there's a dollar equivalent held in USDT's reserve. To be able to pay users when they want to redeem it, hence keeping supply and demand equal which in effect, keeps the price stable. At least, that's what they all led us to believe.

The supposed pegged value of stablecoins came under extreme scrutiny when the stablecoin TerraUSD lost its peg. The consequences of this incident were felt by the entire crypto market. As of this minute, the market is still struggling to get out of the hole this incident drag us into. To understand what happened, we have to understand how UST works. Unlike USDT that's supposedly back 1-1, the UST is an algorithmic stable. Its price control is solely dependent on a programmable blockchain that self controls the price.

TerraUSD is owned by TerraLabs foundation, which is also the owner of Luna. Both these tokens were at the centre of the Luna ecosystem. Why the peg of collateralized tokens like USDT is controlled by the amount of cash equivalent in the reserves, that of UST was dependent on Luna. The price of Luna at the time of the crash was over $100. Because the two tokens were connected, to buy Luna was to bet on the wider adoption of UST. How?

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The Terra blockchain and ecosystem worked in a certain way. Just is pegged at $1, while the price of Luna is free-float. Now, if the price of Luna falls below its $1 peg, say it becomes $0.9, the Terra community is incentivized to buy it, cos they will be getting something worth $1 for $0.9. That buying pressure that is formed by this sentiment will drive the price back to $1. If it goes over $1, people are incentivized to sell, cos they will be getting $1.1 worth of Luna or other coins for something worth $1. So that's how the price is controlled.

The algorithmic part is such that for every UST minted, an equivalent value of Luna is burned, and for every UST burned, an equivalent Luna is minted. If more and more UST is minted, which would be as a result of wider adoption, more and more Luna would be burned, thereby causing scarcity and driving the price of Luna higher. So you see that buying Luna is equivalent to betting on the adoption of UST because they support each other and their ability to function as they should, depends on each other.

I'll be stopping here for sake of not having an article that's too lengthy. Stay tuned for part two where I'll continue this article.

Thanks for your time...

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Avatar for Talon
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2 years ago