In the last couple of days, the world's third-most valuable stablecoin by market cap committed the cardinal sin of stablecoins. UST (USTC -3.01%), the stablecoin that runs on the Terra blockchain and is pegged to the U.S. dollar, plummeted. At one point overnight, it was worth only about $0.30, though it has since partially recovered to about $0.65.

Stablecoins got their names for one reason: They are stable. They are supposed to be worth what they are backed by. Whether that is gold, real estate, or the U.S. dollar, a stablecoin's only purpose is to maintain its value, something that's not expected of most other cryptocurrencies. 

Pile of one dollar bills.

Image source: Getty Images.

UST is unlike other stablecoins because it uses algorithms and smart contracts to maintain its value. In contrast, stablecoins like Tether rely on a reserve of U.S. dollars. Theoretically, for every Tether issued, there should be one dollar in their reserves backing it.

The algorithm is unique because it utilizes the native cryptocurrency of the Terra blockchain, Terra (LUNC 0.20%). Terra are either minted or burned to keep UST near $1. If UST becomes worth more than a dollar, holders of UST can convert their stablecoins into Terra for a profit. If UST is worth less than a dollar, holders of Terra can exchange their coins for UST at an enticing price. This is known as arbitrage.

Terra and UST rely upon each other. If investors do not want to hold either of the coins, the entire ecosystem is at risk of collapse. Most importantly, the ecosystem relies upon UST always being worth $1. If it loses its value, the arbitrage system is dismantled, and the dynamic between Terra and UST is compromised.

More bad news

As if it couldn't get any worse, the nonprofit organization that guides decisions for the Luna ecosystem, Luna Foundation Guard (LFG), has been preparing for an event like this. To mitigate a potential de-pegging from the U.S. dollar, the LFG began purchasing Bitcoin in extraordinary amounts.

The plan was to release these funds of Bitcoin to help repeg the stablecoin. During the last 24 hours, conditions were right for the plan to be implemented. It seems like this plan has not worked. Despite releasing the Bitcoin funds, UST is still trading well below the coveted $1 landmark.

UST is in uncharted territory. This is a catastrophe for a once-promising project. The longer it takes UST to reclaim the $1 value, the more Terra will suffer. In just the last 24 hours, Terra lost about 50% of its value. It is down more than 60% on the week.

Where do UST and Terra go from here? No one can say for sure. The idea of an algorithm-backed stablecoin may become an unobtainable fantasy. Even if UST does get back to $1, investors will have lost trust in the project. Terra needs to prove that this was a fluke and will not happen again. Once UST demonstrates that it has what it takes to navigate this, investors should remain extremely cautious toward Terra and UST.