Terra blockchain last week was halted after its cryptocurrency Terra Luna crashed 99 percent. The stablcoin token fell sharply from a high of $118 last month, to $0.09. On Wednesday, the stablecoin was trading at $0.000218 (at 3 pm IST), according to Coindesk data
After the crash, Terraform Labs stated that it has halted the Terra blockchain in its bid to “come up with a plan to reconstitute it”.
This was not only a setback to the Luna investors but gave a massive blow to the proponents of stablecoins which often argue that stablecoins are far more stable than a conventional crypto token.
Meanwhile, Terra's twitter handle indicated that the stablecoin will bounce back soon, and they are currently trying to find out why, and how, this had transpired.
Before we proceed, let us explain what is a stablecoin.
What is a stablecoin?
It is a type of cryptocurrency with comparatively less volatility in price because it pegs its market value to an external reference asset such as a fiat currency.
They have become popular for offering the features of cryptocurrency along with stability of fiat currency.
Stability offered by these tokens stem from collaterisation or via algorithmic mechanisms of buying and then selling its reference asset such as US dollar or its derivatives.
The first stablecoin was Tether which was created in 2014. Later, several stablecoins were created on its lines.
Stablecoins assure to offer what most cryptocurrencies lack i.e., stability. Let us understand how cryptos fail to serve the purpose of fiat currency.
There are several cryptocurrencies such as Bitcoin, Ethereum, Polkadot and Litecoin built on blockchain technology. But their extreme volatility makes some investors jittery, and rightly so.
Currency is meant to be used to buy goods and services. If they fluctuate wildly on a daily basis, it is unrealistic for the users to value them on the basis of their purchasing power. Consequently, the users will refrain from adopting a currency if they are unsure of its purchasing power the next day.
Since stablecoins offer stability of price, they are seen as relevant alternatives to usually volatile cryptocurrencies.
Currency is made stable because it is backed by collaterals in form of gold or foreign exchange. Since cryptocurrencies lacks these safety nets, it is likely to stay volatile. Stablecoins, although free from regulations, keep collateral to bolster their price stability.
Types of stablecoins
There are essentially three kinds of stablecoins based on the type of collateral they keep.
A. Collateralised via cryptocurrencies: They have a particular cryptocurrency as collateral. Although cryptocurrencies tend to fluctuates a lot, the stablecoins — as a result — keep a greater number of cryptocurrency tokens as backing for fewer number of stablecoins — which is known as overcollateralisation.
B. Fiat collateralised: These coins are backed by fiat currencies such as the US dollar.
C. Algorithmic stablecoins: The non-collateralised stablecoins follow a working mechanism such as that of a central bank, to maintain stability in price. The working mechanism could be to increase or decrease the supply of coins based on the need.
What happened in case of Luna?
Terra network has two native coins LUNA and UST. UST is a stablecoin, and its value is pegged to a currency, commodity or financial instrument. Stablecoins usually achieve this peg by holding equivalent amounts of dollars. UST achieves this peg by engineering the supply and demand of the coin with an algorithm. This is where LUNA comes in.
If UST’s value slides lower than $1, traders are incentivized to swap 1 UST with LUNA equivalent to $1. And then that UST is “burned” to reduce its supply, bringing it back to $1. And conversely, when UST rises above $1, LUNA holders are incentivised to swap it with newly minted UST, and the LUNA is burned.
This increases the UST's supply, bringing it back to $1.
In case of Luna, UST de-pegged. It declined below $1 as a result of large-scale selling. And the swapping mechanism with LUNA just failed to stabilise it.