Terra USD ($UST), an algorithmic stablecoin built on the Terra blockchain, is now the 5th largest stablecoin based on market capitalization.
Considering that $UST was introduced in September 2020, and coming at a time of heightened government scrutiny of stablecoins, this is an impressive feat by any standard.
There are 3 types of stablecoins currently documented:
- Custodial stablecoins are simply backed 1:1 by a centralized entity. For every 1 USDC, Circle holds the equivalent in dollars, and so on with every other coin on the list. This include USDC, Tether, GUSD, BUSD, TUSD
- Over-collateralized debt stablecoins are similar to custodial coins in that they are backed by a currency, but in the case of crypto, are often over-collateralized by a highly volatile asset like Ethereum, Synthetix etc. Examples are Dai, sUSD, LUSD, alUSD
- Algorithmic stablecoins have a wide array of mechanisms to retain their peg ranging from bond purchases to partial collateralization to programmatic contraction and expansion, or even a combination of all of these. Examples are Ampleforth (AMPL), Fei, Frax, TerraUSD (UST).
Unlike most blockchains where custodial stablecoins are essential to avoid volatility, the Terra blockchain created UST, alongside Luna, its native governance and staking token.
This approach helps Terra to pursue the crypto ethos of decentralization and censorship resistance, but also believes that stablecoins are the pillar of the DeFi stack.
UST relies solely on arbitrageurs to maintain its peg. It does this by contracting the supply of UST when it is below peg and expanding Luna and vice-versa when it is above peg.
When UST is below peg, arbitrageurs can mint $1 worth of $Luna by buying and burning UST. They can then sell Luna immediately.
When UST is above peg, they can mint $1 worth of UST by buying and burning $Luna to sell back on the market which is trading at a premium.
Terra points out custodial stablecoins as being vulnerable to government regulation and censorship, which can bring risk to assets of those trading using them.
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