The collapse of the Terra ecosystem, which led to the depreciation of its algorithmic stablecoin TerraUSD (UST) to an all-time low of $0.30, has put doubt on the future of not just algorithmic stablecoins, but all stablecoins in general.

The success and stability of UST were entwined with that of its sibling, LUNA, which generates arbitrage opportunities that should, in theory, keep UST’s price stable. If the price of UST falls below $1, it can be burned for LUNA, reducing the supply of UST and raising its price.

If the price of UST rises above a dollar, LUNA can be burned in exchange for UST, increasing the supply and lowering the price.

As long as conditions are normal and everything works properly, there is a mechanism and an incentive to keep the UST price at $1.

Despite the fact that algorithmic stablecoins are not usually backed by assets such as other stablecoins, the Luna Foundation Guard (LFG), which is responsible for developing UST and the broader Terra ecosystem, has built a war chest of Bitcoin (BTC) to be used if the UST becomes depegged from the US dollar.

The idea is that if the price of UST dips significantly, traders can borrow BTC and use it to buy UST, pushing the price back up and repegging it to the dollar.

As a result, as UST’s price plummeted, LFG distributed more than $1.3 billion in BTC (42,000 coins at $31,000 each) to traders who planned to use it to buy UST, creating demand pressure and strengthening its price. However, that wasn’t enough to salvage the collapsing ecosystem, and the spiral effect eventually brought the price of the LUNA token and its stablecoin to a halt.

Even controlled stablecoins, such as Tether’s USDT, lost their dollar peg in the aftermath of the crash, plummeting to a low of $0.95. The Terra crisis caused a lot of volatility in the decentralized finance sector since stablecoins operate as a bridge between multiple decentralized finance ecosystems.

Regulations for stablecoins all over the world

Stablecoins have been on the radar of authorities in many major economies for some time, but the UST collapse functioned as a catalyst, compelling regulators in the United States, South Korea, and many European countries to pay attention to the flaws in these not-so-stable digital dollar pegs.