What is a stablecoin and why does it matter? After the launch of Bitcoin, certain people wanted the claimed benefits of a digital currency (i.e., 24/7, inherently global, low fees by cutting intermediaries, trustless, immutable, etc.) without the volatility (e.g., it would be no fun buying a coffee at Starbucks and your $3 worth of Bitcoin fell to $2.95 as you paid). Enter stablecoins: cryptocurrencies pegged to fiat currencies (e.g., 1:1 to the USD or Euro or Yuan, etc.)
Types of stablecoins: broadly, there are two categories - backed and not backed. Backed stablecoins are meant to have reserves of assets (like fiat currencies, bonds, commodities, other cryptos, etc.) that are outside forces intended to maintain confidence in the peg. UST (Terra USD) is a non-backed algorithmic stablecoin.
How was UST supposed to work? Instead of having reserves, UST was supposed to maintain its 1 UST:1 USD peg algorithmically via minting and burning coins (the equivalent of increasing and decreasing the money supply in normal macroeconomics).
The peg relies on the fact that LUNA (a sister coin by the same makers of UST) can always be exchanged 1:1 for UST. Thus, rationally:
If the price of UST is > $1 (let’s say $1.1 USD) because the demand for UST is too high, a trader can send 1 LUNA to the system and get 1 UST back (1 LUNA is burned, 1 UST is minted, they make $0.1 risk-free). The supply of UST is therefore larger, so the price of UST should fall
If the price of UST is < $1 (let’s say $0.9) because the demand for UST is too low, a trader can send 1 UST to the system and get 1 LUNA back (1 UST is burned, 1 LUNA is minted, they make $0.1 risk-free). The supply of UST is therefore smaller, so the price of UST should rise
This works in theory, but in practice, this past week certain people have lost confidence in UST and LUNA (much like how people may have lost trust in various financial institutions during bank runs). Instead of UST and LUNA balancing each other, many are getting rid of both. Like many runs before, minor actinos trigger major movements. Thus, the once $18B stablecoin, launched just 20 months ago, has been unable to maintain its 1UST:1USD peg at the lowest falling to 26 cents. Its sister token LUNA has fallen from $82 to $0.008 at the time of writing.
The story is not over because many proposals have been made to re-peg UST and bolster confidence in LUNA. Regardless, this incident has definitely sent a shockwave throughout the crypto markets. Looking historically at the most successful fiat currency, USD was backed by silver and gold, notes, then gold again, before enough confidence was accrued to have the fiat USD we currently have. In other words -confidence is fickle.
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in plain english, what's going on with UST/ the crypto market?
there is an error in the mechanism as written above - when you trade Luna for UST you don’t, it is not 1 LUNA burned for 1 UST minted, the protocol burns Luna and mints UST based on the dollar value via spot prices of Luna. If 1 Luna is worth $100, the trader would get 100 UST.