Today we will look at algorithmic stablecoins, what they are and how one of them is causing an increase in Bitcoin spot purchases.
The largest algorithmic stablecoin is called TerraUSD (UST). It has a market capitalisation of $16 billion, and it is the fourth largest stablecoin behind Tether, USDC, and Binance USD. The first three use (or at least claim to use) physical dollars or cash equivalents as collateralisation. Terra is different as it uses another asset called Luna to stabilise its price. Luna's supply controls the price of UST.
For example, if UST is trading above $1 (say $1.01), traders can send their Luna to a market-making smart contract that will destroy Luna. For every $1 of Luna destroyed, $1 of UST is issued to the trader. Traders can then sell this UST at the market price of $1.01 and make a $0.01 profit. Over time, the increase in UST will drive its price down to the $1 peg. If UST is trading below $1 (say $0.99), traders can send their UST to the market-making contract that will issue them with $1 of Luna, which they can sell for $0.01 profit. The reduction in UST supply will drive the price up to $1. Thus, the expansion and contraction of Luna's supply controls the price of UST.
However, as the supply of Terra has grown, more market participants have become concerned about the stability of this mechanism. There is a genuine risk of the peg breaking. This mechanism works well when there has been a steady inflow of capital into Terra (and a growing Luna price). Still, it also risks entering a death spiral if UST holders lose faith in the stabilising mechanism. The steady inflow has come via the Anchor protocol, allowing traders to earn an above-market return for holding UST. This opportunity has temporarily driven up the demand for UST, but eventually, this subsidised rate will fall back in line with the market, reducing inflow demand.
The founders of Terra and Luna have recognised the risk, and to counter it, they are attempting a new way of backing Luna by using Bitcoin as its reserve. The Luna Foundation has committed to purchasing $3 billion of Bitcoin as a stability mechanism for Terra / Luna. The foundation bought $1 billion bitcoin over the last two weeks of March, contributing to the rise in Bitcoin price. The foundation's goal is for its Bitcoin reserves to back Terra / Luna entirely. Achieving this will mitigate the most significant risk: peg breaking.
The other significant risks for this asset involve the smart contract implementation. The market-making contract issues UST in proportion to the Luna sent in, but for this to work, it must have a reliable price feed; any failure of the pricing mechanism puts the whole mechanism at risk.
There will be more experimentation as the stablecoin battle intensifies. So far, Tether and USDC are the most significant issues, but they are both very centralised and require trust in their organisations and off-chain reserves. Some market participants may prefer a trustless stablecoin, and if Terra can successfully convert its reserves to Bitcoin, it could become the dominant 'trustless' stablecoin.