One of the main features of fiat currency is that it has government backing. All of this logic hinges on the fact that LUNA retains its value as the governance token given the power and the value of the Terra ecosystem. Through this open market mechanics, the demand for UST moves up and thus its value recovers to 1 USD. So when UST drops below the peg (1 USD), arbitrageurs buy up UST, trade it against the blockchain for 1 USD equivalent of LUNA and close the gap by selling LUNA on any crypto exchange thus making a profit. Within the Terra system, the design is such that users can trade 1 USD worth of UST to 1 USD worth of LUNA. LUNA is not mapped to the dollar and holds a floating value in the open market. To keep the value of UST pegged to a USD, Terra uses a mint and burn approach along with its sister coin LUNA which is a native governance token. Terra is a Layer 1 blockchain at the heart of which is an algorithmically backed stablecoin ( UST) that can be used across its defi ecosystem. The downside of the stablecoins is that these are risky and complicated instruments which do not have any backing from the government. It is easy, cheap and fast to execute trades and move stablecoins across exchanges compared to USD since stablecoins remain on chain (no traditional banks come into picture) and are not regulated (no tax liability). For example, if you buy 10 BTC at a dollar each and price shoots to 100 USD per BTC, you can sell 5 BTC for 500USD and hold this in stablecoins to later buy BTC when its value drops below 100. Rather than buying a crypto with another crypto which will make the whole transaction double risky, traders can use stablecoins to speculate on other volatile cryptos. So the next obvious question is what purpose do these stablecoins serve? Stablecoins are mostly used by traders and arbitrageurs who want to quickly encash on price differential among cryptos across various exchanges. These stablecoins are called algorithmic stablecoins since their supply/demand and hence the value is managed by algorithms. When the value crosses 1 USD, the smart contract mints (programmatically created) more stablecoins to increase its supply thus reducing its value. In other words, when the stablecoin value drops below 1 USD, the smart contract burns some stablecoins (programatically destroyed) so as to reduce the supply and induce demand thus driving up its value to 1 USD. Smart contracts act as a central bank and manipulates the supply and demand in such a way that the stablecoin retains its equivalent dollar value. Examples of such coins are UST and Neutrino. The Ver 2.0 of stablecoins try to bring in decentralization by using algorithms to maintain the peg. Because the collateral itself is volatile, such stablecoins need to be overcollateralized. There is a sub class of the Ver 1.0 stablecoins where the collateralizationis through a basket of other cryptocurrencies. This is also capital intensive and wasteful since fiat currency is locked and rendered unusable. But this approach made the stablecoin centralized and regulated since the vault needed to be managed by an agency. i.e for every stablecoin in circulation, there is one USD/equivalent asset sitting in a bank vault so that the market can trade in confidence that the coin has some asset backing. Ver 1.0 stablecoins such as Tether ( USDT) and USD Coin ( USDC) were backed by the USD. These stablecoins were pegged to a fiat currency thus allowing them to hold their price stable.įor the users to trust these stablecoins, they need to be backed by something tangible. This led to creation of a class of cryptocurrencies called stablecoins. In order to drive traction in the crypto market, there was a need for a currency which holds the stability of the fiat currency while still offering crypto like features such as anonymity, low fee, quick settlement. The crypto currency market cap is less than 5% of the US stock market and hence any price movement gets amplified making crypto extremely volatile. But before we look at why this happened, lets understand what exactly is a stablecoin and why it is important for stablecoins to succeed if we are to create a working version of a decentralized economy. A stablecoin called UST which was applauded as one the most elegant concepts in the crypto world sustained huge losses due to sell off that is similar to a traditional bank run. For those who are following the crypto market, last week's stablecoin crash is reminiscent of the days from the financial crisis of 2008.
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