Pedestrians pass by a demonstration of the cryptocurrency bitcoin on February 15, 2022 in Hong Kong, China.

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The multibillion-dollar bet that bitcoin could act as a “reserve currency” for the crypto-economy is already being tested as the UST, the controversial stablecoin, struggles to keep pegged to $ 1.

Last weekend, the UST fell nearly 99 cents, raising concerns about a potential “bank escape” that could force Terra, the project behind it, to plunge into a $ 3.5 billion bitcoin heap to support the token.

Now the Luna Foundation Guard, created by inventor Terra Do Kwon, says it will allocate $ 750 million in bitcoin to trading firms to keep UST price pegged. But that does little to allay investors ’concerns about the implications for bitcoin.

What is UST?

Developed by Singapore’s Terraform Labs, UST is what is known as an algorithmic stablecoin. It aims to serve as a stablecoin, such as Tether, that tracks the price of the U.S. dollar, but without the real cash held in reserve.

Instead, UST – or “terraUSD” – is created by destroying a related token known as luna, using smart contracts, lines of code written in a blockchain.

“If you have, say, $ 405 and you burn one month, you should be able to mint 405 UST stablecoins,” explains Carol Alexander, a professor of finance at the University of Sussex.

The same is true – the new luna is minted by burning UST and other algorithmic stablecoins supported by Terra.

Terra protocols also have an arbitrage mechanism where investors can use deviating prices for each of the tokens. For example, too much demand for UST could cause its price to exceed $ 1. This means that traders can convert a moon worth $ 1 into UST and invest the difference in profits.

The model is designed to balance supply and demand on the UST. If the price of UST is too high, users are encouraged to burn luna and create a new UST by increasing the supply of stablecoin as well as reducing the number of luna in circulation.

“The moon is becoming more scarce, which makes it more valuable, transferring this value to the UST,” says Alexander.

If the price of UST is too low, the opposite happens – UST is burned, and luna is expected. This, in theory, should help stabilize prices.

The problem

“This implies normal market conditions,” said David Moreno Dorokas, an analyst at CryptoCompare.

“During periods of high volatility and unilateral buying / selling activity for the UST the aforementioned stabilizer may not be enough to maintain pegging in the short term.”

There have been several cases where the UST has broken away from pegging to $ 1, raising concerns about the viability of its economic model – especially when several people are trying to redeem their tokens at once.

The last call came over the weekend. Hundreds of UST millions have been sold on Anchor, Terra’s flagship lending platform, as well as on Curve and Binance, leading to allegations of a “coordinated attack” on the Stablecoin.

“Men will be literally unsuccessful in attacking stablecoin instead of going to therapy,” said Do Kwon, a South Korean crypto-entrepreneur who co-founded Terraform Labs, on Twitter.

“Reserve currency”

To address concerns about the stability of the stablecoin, Kwon plans to buy bitcoins worth up to $ 10 billion through the nonprofit Luna Foundation Guard. These funds will provide support in the event of a sharp drop in the cost of UST.

The idea is that bitcoin will act as a “reserve currency” for the Terra ecosystem, just as central banks hold large amounts of dollars in their foreign exchange reserves.

Last week, LFG bought another $ 1.5 billion in bitcoins, increasing total reserves to about $ 3.5 billion. However, on Monday the organization said it was taking steps to “actively defend stability” UST.

This includes a $ 750 million bitcoin loan to trading firms to “protect the UST peg”. and another 750 million in UST are borrowed to buy more bitcoins “as market conditions normalize”.

“In the case of most of these algae stemcoins, we have seen that the teams behind the project usually need to intervene – so they are not yet fully decentralized or managed independently,” said Vijay Ayar, head of corporate development and international cryptocurrencies. exchange Luno.

What does this mean for bitcoin

Investors are concerned that UST-based Bitcoin will lead to further pain for cryptocurrency.

The world’s largest digital coin fell below $ 33,000 on Monday, falling to its lowest level since July 2021. Last time it traded at around $ 32,921, down 6% in the last 24 hours.

LFG’s intervention will “add pressure on sales,” said Derek Lim, head of crypto-insight at Bybit. “BTC is likely to decline before rebounding when short sellers make a profit.”

Kwon insisted that the LFG “is not trying to get out of its position in bitcoins.”

“As markets recover, we plan to repay our BTC loan by increasing our total reserves,” he said.

The plan is to eventually allow UST holders to redeem their tokens in exchange for bitcoin. Bitcoin will play the role that luna normally plays in a crisis scenario, when arbitrageurs buy UST and then exchange it for discounted bitcoins. But it is still a few weeks before this is realized, and it is unclear how it will work in practice.

The biggest risk moving forward will be another UST downsizing, which will force LFG to eliminate its bitcoin stocks, said Hendo Verbeck, head of the Faculty Group’s quantitative trading operations department. This, in turn, could lead to further elimination of buyers with “excess credit”, says Verbeck.

“It’s a nightmarish scenario that looks like the real result of events,” he said.

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