The 2 leading stablecoins – Tether ( $USDT) and USD Coin ( $USDC) – are backed by reserves of U.S. dollars and other assets in an effort to maintain their 1:1 peg to the United States Dollar.
Algorithmic stablecoins, on the other hand, maintain their peg to fiat by employing algorithms that let traders create and destroy coins as needed to maintain their price.
According to proponents, this kind of stablecoin is the right option for Decentralized Finance (DeFi) because the cryptocurrency’s value is not guaranteed by fiat assets held in financial institutions.
Some of the leading stablecoins that employ this method include:
- TerraUSD ( $UST)
- Frax
- FEI USD
So how does it all work?
How $UST Maintains Its Peg
$UST is one of several stablecoins in the Terra protocol, each tracking different fiat currencies. $UST tracks the dollar, while others track the Euro, Japanese Yen, the IMF SDR etc.
The Terra Protocol runs on a Proof-of-Stake (PoS) blockchain where miners need to stake its native cryptocurrency, $luna, to mine Terra transactions. $LUNA, therefore, represents mining power on the Terra network.
$LUNA holds $UST in check:
The system uses $LUNA to make the price for Terra by agreeing to be counter-party to anyone looking to swap Terra and $LUNA at Terra’s target exchange rate.
- When $UST price < $1, users and arbitragers can send 1 $UST to the system and receive $1 worth of $LUNA
- When $UST price > $1, users and arbitragers can send $1 worth of $LUNA to the system and receive 1 $UST
As such, when $UST drops to, say $0.9, an arbitrageur can extract risk-free profit by trading $UST for $1 worth of $LUNA from the system, as opposed to $0.9 worth of assets one could get from the open market.
Similarly, one can also extract risk-free profit when 1 $UST = $1.1 by trading in $1 worth of $LUNA to the system to get $1.1 worth of $UST, once again beating the price of the open market.
The system finances Terra price making via $LUNA:
- To buy 1 $UST, the protocol mints and sells $LUNA worth $1
- By selling 1 $UST, the protocol earns $LUNA worth $1
As $LUNA is minted to match Terra offers, volatility is moved from Terra price to $LUNA supply. The system burns a portion of the $LUNA it has earned during expansions so that the crypto doesn’t devalue.
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RECOMMENDED READING: EXPLAINER: Inside DAI – An Algorithmic Crypto-Collateralized Stablecoin
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