Crypto Carnage Pummels Terra’s LUNA Coin as the UST Stablecoin Loses Its Peg and Bitcoin-based Intervention Fails To Restore Stability

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Terra (LUNA), a public blockchain protocol that powers a number of non-collateralized stablecoins, is facing its most serious threat yet as the carnage in the broader crypto sphere has de-pegged TerraUSD (UST) and caused LUNA coin's price to crash over 50 percent in the past 24 hours.

Source: https://coinmarketcap.com/currencies/terra-luna/

As a refresher, the TerraUSD (UST) is a stablecoin pegged to the US Dollar. Terra maintains this peg by algorithmically adjusting the supply of UST and LUNA. If the price of UST falls below $1, the supply of UST is burnt by minting LUNA, thereby restoring the peg. On the other hand, if the price of UST exceeds $1, LUNA is burnt to mint more UST, thus increasing the stablecoin's supply and reducing its price.

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In order to augment this stabilization mechanism, Terra is also working on introducing an on-chain Bitcoin (BTC) reserve, which would help in restoring stability during periods of abnormal volatility. Under this arrangement, the Luna Foundation Guard (LFG) will place Bitcoin worth at least $2.5 billion in a reserve pool. In periods of heightened volatility, if the UST peg falls well below $1, arbitrageurs can swap UST for BTC, thereby reducing the quantum of UST in circulation and increasing its price. The opposite would occur if the price of UST were to substantially increase over the $1 peg.

Nonetheless, readers should note that Terra has yet to officially deploy its on-chain Bitcoin reserve system, with the LFG still working to acquire Bitcoin worth around $3 billion.

This brings us to the crux of the matter. Citing increased volatility, Terra's LFG Council instituted a stop-gap measure yesterday to try to restore UST's $1 peg. As has been detailed in the Twitter thread above, the council loaned Bitcoin worth $750 million to OTC traders in order to try to restore the peg. However, this attempt has so far failed, with UST currently trading at $0.91. Bear in mind that at the height of the crisis, the UST was trading at an unthinkable $0.69 price level:

Conviction Around a Sub-$20,000 Bitcoin Price Keeps Growing

Source: https://coinmarketcap.com/currencies/terrausd/

So, what happens next? Judging by the recent price action, the UST is expected to reclaim its peg soon, barring the onslaught of extreme volatility. Nonetheless, this episode has clearly demonstrated the fragility of algorithmically pegged stablecoins.

Crucially, while Terra's on-chain Bitcoin reserve system is yet to be deployed, the LFG did try to replicate this mechanism by loaning out Bitcoin. However, the measure has so far failed to restore stability, thereby exposing the underlying shortcomings in Terra's business model.

As if Terra's ongoing travails were not enough, there is chatter now that the US government might ban all USD-based stablecoins, eliminating the entire raison d'etre of Terra.

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