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Analysis

Unearthing the Biggest Algorithmic Stablecoin: UST by Terra

by Benjamin Hor -

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When we talk about algorithmic stablecoins, we often think of Ethereum-based protocols like Empty Set Dollar or Frax Finance. Newcomers like Fei Protocol and the upcoming launch of Gyroscope are also on everybody’s watchlist. Many have concluded that Frax Finance is one of the leading protocols taking its cue from its highly successful, fractional reserve/partially collateralized model. 

While Frax Finance has undoubtedly proven it is here to stay (one only needs to look at how well it maintained its peg during Bitcoin’s recent crash), another sleeping giant has not garnered the same attention in the community. We are, of course, talking about TerraUSD (UST).

To understand why we classify UST as an algorithmic stablecoin, we first have to define what an algorithmic stablecoin is. As its name suggests, algorithmic stablecoins utilize algorithms to control the stablecoin’s market structure and the underlying economics. You may think of algorithmic stablecoins as an automated Federal Reserve, where instead of human-made decisions, pre-programmed code executes specific actions to control and influence the price. 

While most can agree on that general definition, there has rarely been a definitive consensus on the finer details. Some might argue that it requires an arbitrage mechanism, while others believe that its collateralization ratio is an important consideration. We believe that an asset qualifies as an algorithmic stablecoin if it has any of the following characteristics:

  1. Has no collateral; and/or

  2. Is partially/fully collateralized by their own native token; and/or

  3. Has a floating peg.

We believe this captures the meaning behind algorithmic stablecoins because possession of these characteristics requires algorithmic functions to stabilize the price in order for the protocol to maintain its peg. 

There are some semantics on whether UST falls under point 1 or point 2 because although UST is not explicitly collateralized by LUNA (its share-token counterpart), there are those who would argue that LUNA is effectively ‘endogenous collateral’ for UST because of their arbitrage relationship (further discussed below). Regardless, UST would still fall within our definition of an algorithmic stablecoin.

TerraUSD (UST) Market Capitalization

Source: CoinGecko

Since UST’s genesis in September 2020, the algorithmic stablecoin has exploded in popularity and grew exponentially to $2B in just 7 months - this eventually catapulted it into the top-5 stablecoins by market capitalization.

However, unlike other algorithmic stablecoins, UST and LUNA cannot be discussed in isolation. UST is built as one of the core currencies of the Terra blockchain and is integral to how the network functions. Therefore, we must look at the entire ecosystem to understand why UST is as successful as it is. 

Throughout this report, we will be looking into the background of Terraform Lab, Terra Stablecoins, the role of LUNA, and the factors that contribute to UST’s successes. The report will also cover the May Bitcoin (BTC) crash and conclude with our view on UST’s future.

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