The recent sell-off of the crypto market was highlighted by Terra’s LUNA/UST failure, which left investors in shambles, erased tens of billions of dollars of value in a matter of days, and most likely will induce a strict stablecoin regulatory policy response in the near future.
TerraUSD, or UST, was designed to be an algorithmic stablecoin — a specific digital asset pegged to the value of one U.S. dollar. To maintain their value, algorithmic stablecoins are backed by a set of smart contracts on the blockchain, also referred to as a “protocol” that requires collateral in the form of other digital assets to be put into the system in order to issue algo-stablecoins.
In contrast to reserve-backed stablecoins — which rely on a third-party organization to manage monetary supply and maintain adequate reserves, usually in the form of U.S. Treasury bonds, cash equivalents or other traditional assets — algorithmic stablecoins do not rely on a third party but rather on programmable software to control the supply and maintain adequate collateral.
The particularity of UST, which made it very susceptible to a bank run was that UST liabilities were backed predominantly by LUNA, a sister cryptocurrency native to the same underlying network — the Terra blockchain. Every time anyone wanted to create an emission of UST, a certain amount of LUNA needed to be taken out of circulation (burned). And vice versa, every time anyone burned UST, they created (minted) LUNA…
