When Terra broke crypto: the LUNA UST crash explained

When Terra broke crypto: the LUNA UST crash explained

In May 2022, Terra, a popular blockchain protocol that supports decentralized stablecoins pegged to fiat currencies and uses Bitcoin reserves to secure this peg, lost over 99% of its value. This caused one of the most brutal cryptocurrency market crashes in recent memory.

What you learned from the Terra Luna UST crypto crash:

• The scope of the 2022 crypto novel
• How the land-based stablecoin crisis happened
• Implications of stablecoins and cryptocurrency decentralization

How bad was the cryptocurrency crash of 2022?

In the second week of May 2022, flagship digital assets Bitcoin and Ethereum lost nearly 40% of their value in just a few days, as the cryptocurrency market took a severe downturn, losing over $600 billion. Bitcoin traded at $25,400 on May 12, down from $40 just a week earlier, while Ethereum lost nearly half its value, falling from $2,900 to $1,700 over the same period. Younger altcoins underperformed as the cryptocurrency industry plunged into a wave of panic selling and mass liquidations.

Perhaps significantly, cryptocurrencies weren’t the only industry. Crypto’s messy week of losses came amid a slump in global stock markets as inflation and the post-pandemic recession worsened. Global indices were at year-to-year levels, while inflation in parts of Europe and America was at its highest level in decades.

Despite the circumstances surrounding the event, with Bitcoin responding to the same dynamics weighing on risk assets globally, Terrassa seems the obvious scapegoat. Terra, a blockchain payment platform also made up of two algorithmic stablecoins, lost virtually all of its value during this time, losing tens of billions of dollars in value and destroying the wallets of thousands of cryptocurrency investors. The crash sent further shockwaves through the cryptocurrency market, exacerbating a sell-off that undermined investor confidence in the proposed solution to the volatility of stablecoins and cryptocurrencies.

How the crisis of the Terra stablecoin happened: Terra, LUNA and UST

Algorithmic stablecoin: an alternative to centralized stablecoins

To understand what is happening on Earth, it can be helpful to first understand what a stablecoin is. Basically, a stablecoin is a cryptocurrency whose value is pegged to another currency. The most popular stablecoins are Tether (USDT) and USD Coin (USDC), both pegged to the US dollar.

Stablecoins were intended as a solution to the extreme volatility of cryptocurrencies and to provide investors with a way to keep their holdings at a more predictable value. For example, instead of owning Bitcoin, which fluctuates in value, investors can convert their cryptocurrency into USDT, as 1,000 USDT is always redeemable for 1,000 USD (with very small fluctuations).

Stablecoins such as USDT and USDC are backed by effective reserves in US dollars, theoretically at a 1:1 ratio. This means that for every USDT or USDC issued, issuers must also hold one US dollar in reserve. Current companies have to manage this balance manually: USDT is managed by a company called Tether, while USDC is managed by a company called Centre.

But stablecoins have historically been problematic. Because they are still centralized currencies, they have not been able to be fully transparent about their internal operations and are seen as vulnerable to manipulation by political and commercial interests.

However, an algorithmic stablecoin like Terran’s FSO opts for a more “decentralized” form of stablecoin, using highly sophisticated computer algorithms – and reserves of Bitcoin instead of US dollars – to maintain a peg to the dollar by automatically expanding or decreasing based on the prevailing markets. requirements. It’s also meant to be decentralized, making it resistant to potential manipulation.

Relationship between Earth, FSO and MOON

The Terra Network, like Bitcoin or Ethereum, verifies transactions on the network and produces or mines its own native cryptocurrency called LUNA. So to create the UST stablecoin, LUNA must be “burned” or redeemed. A LUNA token, when burned, would generate a UST token equal to its US dollar value.

So, if LUNA was worth $80, burning 1 LUNA would generate 80 UST worth $80. Conversely, if 1 LUNA was needed for the Terra network, 80 UST would need to be burned.

The concept here was simple deflation. As demand for UST increases, the network would burn through more LUNAs, making the supply scarcer and more valuable.

Defend UST’s link to Bitcoin assets

The gist of the UST promise was this: You can always exchange 1 UST for $1 of LUNA.

So even though UST is trading at $0.99 (the general range of variance for stablecoins), you can still make a profit by buying UST for 99 cents and trading it.

The problem then is the appreciation effect confirmed by trades such as buying UST increases the price, burning UST to get LUNA during the agreed trade for UST supplies. As demand increases and supply decreases at the same time, the price pressure from the FSO increases. This requires active intervention by Terra to maintain the $1 peg.

This is where Terra’s used Bitcoin reserves come into play. The reserves are managed by a consortium called the Luna Foundation Guard (LFG). LFG had purchased around $2.3 billion worth of Bitcoin for its reserves. If the price of the UST exceeded $1, LFG would sell the UST to bring the price back to par and increase its reserves. On the other hand, if the UST price falls below $1, LFG would buy UST with reserves to bring it back to parity.