What is UST and what does it mean for the peg to drop?
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Cryptocurrencies were intended to be alternative currencies that people would use in all kinds of everyday financial transactions. However, in practice, they are far too volatile to be used for this purpose: the value of $1 isn’t going to collapse by 50% by next week, but with Bitcoin that’s always a serious possibility.
To solve this problem, a number of people have developed “stablecoins”, cryptocurrencies which are designed to maintain stable prices relative to normal currencies or real-world assets. These have essentially become the standard currencies of the cryptocurrency industry. Where possible, most people prefer to carry out transactions in stablecoins, and keep their reserves in stablecoins, only switching to standard cryptocurrencies when they have to or when they want to gamble that their prices will go up.
There are a number of different mechanisms by which stablecoins are “pegged” to normal currencies or assets, but because of the unregulated “Wild West” nature of cryptocurrency, most of them are a little dubious. Terra, or UST, is an “algorithmic” stablecoin that was supposed to maintain a constant price of $1 by using an associated free-floating cryptocurrency called “Luna” as a kind of buffer. When the price of Terra falls below $1, traders are incentivised to buy Terra, swapping it for Luna, and when the price rises above $1 they’re incentivised to sell Terra, swapping it for Luna. In theory this was supposed to mean that Luna should absorb price falls or rises, keeping the price of Terra constant.
But this mechanism only has limited power to absorb price shocks, and in the recent cryptocurrency crash the value of UST fell a few cents below $1. This led to a widespread loss of faith that the currency would remain pegged to the US dollar, causing its price to crash dramatically – at one point it was trading at around $0.3, though now it’s up to around $0.5.
It’s worth noting that this kind of thing does occasionally happen with normal currencies – governments have quite often chosen to peg their currency to some other currency, or to a commodity like gold, and the mechanisms they use to do this have sometimes failed. But governments have a lot more power to intervene in markets to maintain currency pegs, and they face serious consequences if their currency collapses. The companies behind stablecoins tend to be fairly small startups with limited power to intervene in the markets, and they often manage to squirrel away their profits in tax havens so that it’s not the end of the world if their currency collapses.
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