Observers like Ryan Clements, assistant law professor at the University of Calgary, said the situation shows the flaws in the system.
“Algorithmic stablecoins are inherently fragile,” he said in an email. “I had previously warned in months leading up to the failure that there were many vulnerabilities in this ecosystem.”
How it works
TerraUSD and a sister coin with free-floating value, Luna, are locked in a relationship meant to keep the stablecoin’s dollar value. If the price of Terra rises above $1 because of investor demand, a Luna holder can swap $1 worth of Luna for that coin, making a profit from the higher price, which pushes the value back to $1. Conversely, when the coin drops, traders can make a profit by swapping it for $1 worth of Luna. This reduces the supply, raising the price.
But this system relies on the ability to mint ever increasing supplies of Luna to make the transaction worthwhile. Last week, Luna lost 99 percent of its value, forcing the system to create trillions of Luna coins to keep up.
“Once trust and investor demand evaporate, they quickly fail in a death spiral — and we saw that with UST / Luna,” Clements wrote. “Going forward I hope that there are thoughtful regulatory discussions and policy formation in this space, as I’m sure there have been some tragic losses by unsuspecting retail investors in both coins that didn’t understand how fragile their so called ‘stablecoin’ was to begin with.”