Arbitration options for speculators
UST is a decentralized algorithmic stablecoin, meaning it doesn’t have a dollar backing it like Tether’s USDT or Circle’s USDC. Instead, the link is controlled by smart contracts.
Investors can always exchange 1 UST for $1 in LUNA, and vice versa. Each time this trade is made, the UST traded for LUNA is destroyed and removed from circulation. Conversely, when LUNA is traded for UST, that LUNA is destroyed.
This creates an attractive arbitrage opportunity for savvy speculators. That’s because every time UST drops below its dollar peg, there’s an opportunity to buy that discounted stablecoin and then trade it for the $1 in LUNA. In this way, an investor can make a profit. In addition, of course, it also removes UST from circulation and adds buying pressure to the stablecoin. These two market forces work to bring the peg back to dollar parity.
Users can exchange LUNA worth $1 for a UST worth more than a dollar on the open market. They can then claim the difference themselves. As the newly minted UST is sold in the market, it adds selling pressure to the stablecoin and pushes the stablecoin back to its peg.