Bitcoin investors are panicking as a controversial crypto experiment unravels

Investors in bitcoin are in panic mode as the controversial terraUSD stablecoin slips further from its intended $1 peg.

TerraUSD, or UST, sank below 70 cents for the first time late Monday, as holders continued to flee the token in what some have described as a “bank run.” The token fell as low as 62 cents before regaining ground to trade at 90 cents Tuesday, according to Coinbase data.

Created by Singapore-based Terraform Labs in 2018, UST is what’s known as an “algorithmic” stablecoin. Part of the Terra blockchain project, it’s meant to track the value of the dollar, like fellow stablecoins tether and USDC.

However, unlike with those cryptocurrencies, Terra doesn’t have cash and other assets held in a reserve to back its token. Instead, it uses a complex mix of code — alongside a sister token called luna — to stabilize prices.

UST is important for bitcoin investors as Luna Foundation Guard, an organization supporting the Terra project, is sitting on billions of dollars in bitcoin that could potentially be dumped onto the market at any point.

“Every professional investor in crypto has one eye on UST today, watching to see if it can maintain its peg to the dollar,” said Matt Hougan, chief investment officer at Bitwise Asset Management. “There’s clearly significant risk in the market.”

In simple terms, the Terra protocol destroys and creates new units of UST and luna to adjust supply. When the price of UST falls below the dollar, it can be taken out of circulation and exchanged for luna, making UST’s supply more scarce and boosting its price — at least, that’s how it should work in theory.

To further complicate things, Terra’s creator, Do Kwon, bought $3.5 billion worth of bitcoin to provide a backstop for UST in times of crisis. The theory was that UST could eventually be redeemed for bitcoin instead of luna, but this is untested and hasn’t yet been put into practice.

Deposits into Anchor, Terra’s flagship lending protocol, have declined from 10.3 billion tokens on May 6 to just 6.4 billion Tuesday, according to data from blockchain analytics platform Nansen. Anchor offered users an almost 20% annual percentage yield on their UST holdings, a rate many analysts believe was unsustainable.

On Monday, Kwon’s Luna Foundation Guard said it would lend $750 million worth of bitcoin to trading firms to “help protect the UST peg,” while a further 750 million UST will be lent out to buy more bitcoin “as market conditions normalize.”

In a follow-up tweet, the organization said it had withdrawn 37,000 bitcoins — worth more than $1 billion at current prices — to lend out. “Very little” of the borrowed bitcoins have been spent, Luna Foundation Guard said, but it is “currently being used to buy” UST.

Several crypto investors are worried that Luna Foundation Guard might have sold, or will sell, a large portion of its bitcoin to prop up UST — analysts pointed out that the group’s bitcoin wallet is now completely empty.

Amid all of this uncertainty, UST’s decline has sent shock waves throughout the crypto market.

Bitcoin, the world’s largest digital currency, briefly fell below $30,000, hitting its lowest price since July 2021. As of 7:00 a.m. ET, bitcoin was trading at $31,324, down around 5% in the last 24 hours. It’s now down more than 50% from its November all-time high.

Luna, UST’s counterpart, has roughly halved in value in the past 24 hours. It was last trading at a price of $32.

Adding to UST holders’ woes, Binance, the largest crypto exchange by market volume, temporarily suspended withdrawals of both UST and luna “due to a high volume of pending withdrawal transactions,” citing network congestion.

Binance has since resumed withdrawals, and says it “will continue to monitor” network conditions.

“I think the market is expecting some forced selling here on the part of Terra and the reserve,” Nic Carter, co-founder of Coin Metrics, told CNBC. “It is a calamity but very expected. No algorithmic stablecoin has ever succeeded and this is no exception.”

He added that the problem with UST is that it’s largely “backed by faith.”

“It’s not fully guaranteed, it’s certainly not fully backed by reserves,” he told CNBC. “It was really just backed by faith in the issuer effectively.”

Terraform Labs did not respond to multiple requests for comment.