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In the last few days, a stablecoin called TerraUSD and its sister currency Luna dropped about 80 per cent, rattling the broader crypto market including tokens like Bitcoin and Ethereum. Terra Luna is now almost worthless. This has created fear among investors, even aggressively bullish crypto investors are now panicking. Here are the five important things to know about the Luna crypto crash.
Terra's Luna Crypto Crash: How UST Broke and What's Next
Luna's value has crashed from over $110 to a fraction of a penny. Its creator thinks he has a plan to undo the damage.
The cryptocurrency market isn't a safe place right now: Look in any direction and you'll see red. Bitcoin and ether are at their lowest points since 2020, and altcoins like dogecoin and cardano are faring even worse. While it's painful for crypto investors, this dive isn't unprecedented. Cryptocurrencies are infamous for their volatility, and tempestuous economic conditions are bringing down not just crypto, but the stock market too.
What is unprecedented, however, is the collapse of the luna cryptocurrency and its associated terraUSD stablecoin, aka UST. You may not have heard of UST before, or know what a stablecoin is, but it's a big deal. Billions of dollars in crypto wealth have been vaporized, sending shockwaves throughout the whole market.
There are two intertwined stories here: That of the UST stablecoin and that of luna, both of which are part of the terra blockchain. The UST coin is designed to retain a value of $1 at all times, but it was depegged last Monday, on May 9, and has since fallen to just 13 cents. Then there's luna, the centerpiece of terra's ecosystem. Its value has collapsed in one of the most stunning crypto crashes ever recorded.
The coin's price fell from $116 in April to a fraction of a penny at the time of writing. Such an implosion has been seen in small-cap memecoins in the past, but never for something the size of luna, which had a market cap of over $40 billion just last month.
"This is historic for the crypto markets," said Mike Boroughs, co-founder of crypto investments firm Fortis Digital. "This is a defining moment for the space due to its size and impact in terms of the amount of people that lost substantial value."
Here's what you need to know.
What's a stablecoin?
To understand the crypto catastrophe, you first need to know what a stablecoin is. In essence, it's a cryptocurrency that's pegged to a more stable currency. The biggest such coins are tether and USDC, which like most stablecoins are both tied to the US dollar. So if you have 1,000 USDC tokens, for instance, they can at any time be exchanged for $1,000.
Stablecoins are integral parts of "DeFi," or decentralized finance, designed to be ways for investors to hedge against the volatility of the cryptocurrency market. Say ether's price is $2,000 -- a trader could exchange one ether for 2,000 USDC tokens. If tomorrow ether drops 50% to $1,000, those 2,000 USDC tokens would still be worth $2,000 and could be traded for two ether tokens. When investors smell a downswing coming, they put their money on stablecoins like tether, USDC and, until this week, UST.
Stablecoins also provide the means for cryptocurrency loaning and borrowing, making them a foundational technology of DeFi.
The terra/UST coin is different from tether and USDC in a key way -- it's not backed by actual US dollars, but rather is what's known as an algorithmic or decentralized stablecoin. (Tether's US reserves have come under scrutiny in the past, with there being some conjecture over how many dollars it actually holds -- but it's US dollar backed in principal.) The idea is that, through a few clever mechanisms, plus billions in bitcoin reserves, the UST's dollar peg can be maintained without it having to be backed by the dollar.
"A decentralized stablecoin is the Holy Grail of DeFi," said Cyrus Younessi, former head of risk management at MakerDAO, the group behind DAI stablecoin. The selling point of bitcoin and ether is that they're difficult for bureaucrats, politicians and central bankers to control, but their downside is price volatility. "If you could take those assets, extract stability out of them and productize it, then that's huge," Younessi said.
"But it's not very viable."
Terra, luna and UST: What are they?
Terra is a blockchain, just like ethereum and bitcoin. While ethereum's blockchain natively produces ether tokens, terra natively produces luna. Before the depeg, luna was trading at $85.
To create UST, you need to burn luna. So for instance, last week you could trade one luna token for 85 UST (since luna was worth $85), but the luna would be destroyed ("burned") in the process. This deflationary protocol was meant to ensure luna's long-term growth. As more people buy into UST, more luna would be burned, making the remaining luna supply more valuable.
To entice traders to burn luna to create UST, creators offered an insane 19.5% yield on staking -- which is essentially crypto terminology for earning 19.5% interest on a loan -- through what they called the Anchor Protocol. Instead of parking your savings at a bank for a 0.06% interest rate, the pitch is to turn put your money into UST, where it can earn nearly 20% in interest. Before the depegging, over 70% of UST's circulating supply, around $14 billion, was deposited in this scheme.
Here's the key to UST retaining its peg: 1 UST can always be exchanged for $1 worth of luna. So if UST slips to 99 cents, traders could profit by buying a huge amount of UST and exchanging it for luna, profiting 1 cent per token. The effect works in two ways: People buying UST drives the price up, and UST being burned during its exchange to luna deflates the supply.
Then there's the reserves. Terra founder Do Kwon created the Luna Foundation Guard, a consortium whose job it is to protect the peg. The LFG had about $2.3 billion in bitcoin reserves, with plans to expand that to $10 billion worth of bitcoin and other crypto assets. If UST dipped below $1, bitcoin reserves would be sold and UST bought with the proceeds. If UST goes above $1, creators would sell UST until it goes back to $1, with the profit being used to buy more bitcoin to pad out the reserves.
It all makes sense. But UST, at the time of writing, is worth 13 cents. How?
What went wrong?
It all started on Saturday, May 7. Over $2 billion worth of UST was unstaked (taken out of the Anchor Protocol), and hundreds of millions of that was immediately sold. Whether this was a reaction to a particularly volatile period -- the rise in interest rates has particularly affected cryptocurrency prices -- or a more malicious attack on Terra's system is a topic of debate.
Such huge sells pushed the price down to 91 cents. Traders tried to take advantage of arbitrage, exchanging 90 cents worth of UST for $1 worth of luna, but then a speed bump appeared. Only $100 million worth of UST can be burned for luna per day.
Investors, already flighty in the current gloomy market, flocked to sell their UST once the stablecoin couldn't retain its peg. It bounced between 30 cents and 50 cents in the week following the initial depeg, but has now fallen to a steady low of under 20 cents. Its market cap, which was around $18 billion in early May, now stands at $2 billion.