One type of cryptocurrency, a so-called stablecoin, is meant to keep its value at $1. But on Monday, the third-biggest stablecoin, TerraUSD, fell as low as 95 cents, causing a flood of investors to sell their holdings.
Stablecoins get their name from their being tied to the value of government-issued currencies, such as the dollar. These $1 pegs are usually backed by Treasurys, cash and other dollar debt that is easily sold in times of market stress.
Unlike traditional stablecoins, TerraUSD is an algorithmic stablecoin. These pseudo dollars aren’t necessarily backed by any assets at all, instead relying on financial engineering to maintain their link to the dollar.
Such designs have been criticized by market observers as risky because they rely on traders to push its value back to $1 rather than having assets that continuously support the price. If traders aren’t willing to buy it, coins can go into a so-called death spiral. TerraUSD has mostly maintained its dollar peg but it has been broken in bouts of heavy volatility.
In TerraUSD’s case, if its price falls below $1, traders can “burn” the coin—or permanently remove it from circulation—in exchange for $1 worth of new units of another cryptocurrency called Luna. That reduces the supply of TerraUSD and raises its price. Conversely, if TerraUSD climbs above $1, traders can burn Luna and create new TerraUSD. That increases supply of the stablecoin and lowers its price back toward $1.
The break in the peg, which began over the weekend, started with a series of large withdrawals of TerraUSD from Anchor Protocol, a sort of decentralized bank for crypto investors built on the technology of the same Terra blockchain network that TerraUSD is based on, said Ilan Solot, a partner at crypto hedge fund Tagus Capital LLP. In tandem, TerraUSD was also being sold for other stablecoins backed by traditional assets through various liquidity pools that contribute to the stability of the peg, as well as through cryptocurrency exchanges.
The dislocation of TerraUSD from its peg caused some traders to panic and sell. To reinstate the peg, others began selling ether and buying TerraUSD, weighing on the dollar value of the second-largest cryptocurrency by market value. Some traders also sold bitcoin over the weekend in anticipation that the platform would need to sell its bitcoin reserves to support the peg, Mr. Solot said.
The Luna Foundation Guard, a nonprofit supporting Terra, said it voted to support TerraUSD by lending $750 million worth of bitcoin to trading firms to protect the stablecoin’s peg and lending out an additional 750 million in TerraUSD to buy more bitcoin.
The selloff might have stemmed from someone or a group of people trying to break the peg, Mr. Solot said. Regardless of the cause, he doesn’t expect TerraUSD to return to $1 immediately as a queue of sell orders are still waiting to be processed.
“I don’t think this peg is going to come back soon,” he said. “There’s so much [TerraUSD] still to come out of the system and that’s going to continue putting pressure on the peg.”
Write to Caitlin Ostroff at caitlin.ostroff@wsj.com
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