What caused Terra Luna to crash?

The project which was one of the top 10 cryptocurrencies “collapsed” within one week, UST lost its peg to the US dollar, and Luna token dropped in value by more than 99%. Today we’ll look into why this happened.

Terra project crash, their cryptocurrency Luna and the fall of the UST stablecoin

In November 2021, most crypto-assets reached their peak values. Since then, the market has been gradually slipping into a bearish mood. The flagships among cryptocurrencies such as Bitcoin and Ethereum fell in value to their lowest levels since 2020. This didn’t really surprise experienced investors ( unlike novice ones ), as the cryptocurrency market is known for high volatility. But what happened to Terra was not overlooked.

Luna cryptocurrency and UST Stablecoin are the native assets of the Terra project. For those who are new to crypto and don’t understand what stablecoins are and how Terra’s blockchain is structured, we will briefly go over these details. This is essential to understand the scope of what has happened.

What is stablecoin?

Stablecoin is a cryptocurrency tied to a more stable asset. The largest examples of stablecoins are Tether and USDC — they are backed by US dollars. Each stablecoin must be as close as possible to the value of the asset to which it is pegged. So, for example, if you have 1,000 USDT, they can be exchanged for 1,000 USD.

In the cryptocurrency world, stablecoins play an important role and allow

investors to maintain value in a volatile market. Let’s take one ETH coin as an

example. The price of 1 ETH is 2000 USD and you will get 2000 USDT by selling

it. It does not matter how the ETH price will change. You will be able to

exchange your 2,000 USDT for 2,000 USDT. If the price of ETH drops by 2 times,

you will be able to buy 2 ETH for 2000 USDT.

When the bear market comes, investors try to save their deposit by exchanging volatile crypto-assets for stablecoins. Not all stablecoins are structured in the same way. As mentioned above, there are those backed by fiat money. But there is another type called algorithmic stablecoins.

UST Algorithmic Stablecoin

UST stablecoin differs from USDC and Tether in that it is not backed by fiat money. Terra’s Stablecoin is an algorithmic or decentralized Stablecoin. The idea is to maintain a peg to the US dollar through certain mechanisms (we will discuss these mechanisms later) and a bitcoin reserve. With this approach, there is no need to back the stablecoin with fiat money.

For investors, stablecoins act as an “island of safety” where they can wait out the “storm” in the market and preserve their assets. Having dealt with stablecoin, let’s move on to what happened to Terra.

The beginning of Terra’s collapse

The Terra project was based on two factors: UST stablecoin and Luna native token. UST is meant to be pegged to $1 as closely as possible. A few weeks ago it lost its peg and at the time of writing this article the UST price is $0.06. The fall of Terra’s stablecoin was accompanied by a parallel decline in the value of Luna tokens. The value of Luna collapsed by more than 99% in a matter of days!

At its peak, Luna reached $116 per coin. Now the price is $0.00017. Such a “steep drop” would be expected from an altcoin that “skyrocketed” amidst the hype and went to the “bottom” as interest faded. In Terra’s case, we are talking about a project that was one of the top 10 cryptocurrencies,?and second only to Ethereum blockchain in terms of TVL (total value of locked assets in smart contracts).

Terra was growing rapidly and was in great demand among investors. It is worth mentioning that?the largest cryptocurrency exchange, Binance, held $1.6 billion worth of Luna, which turned into $3,000. It begs the question: if the team of the world’s largest exchange could not foresee such an outcome, could an average investor do it?

Luna and UST interaction mechanics

As mentioned earlier, UST is an algorithmic stablecoin. To create a UST, it is necessary to “burn” Luna tokens. For example, a user wants to exchange 100 USTs for a certain number of Luna tokens (the number depends on the current Luna price). When the transaction is completed, the user receives 100 UST and the Luna tokens are “burned”. This approach reduces the circulating supply and has a positive effect on the price of Luna cryptocurrency.

To increase Luna burning and UST mint, the Terra team has created an option for investors to stake stablecoins at 20% on the?Anchor Protocol?platform. Such a move worked even before the ‘crash’: more than 70% of UST was in staking. You can learn more about how the Anchor Protocol platform works?here.

Another mechanism that kept the value of UST 1:1 against the US dollar was the ability to exchange 1 UST for the equivalent of 1 dollar of Luna tokens. If the price of UST falls to 99 cents, there is an opportunity to make money on arbitrage. Investors can buy USTs and exchange them for Luna. This way, the profit will be 1 cent on each UST token. In this way, the demand for UST stablecoin increases, and the burning of Luna contributes to the growth of the Luna cryptocurrency.

In addition to the tools listed above, Terraform Labs created a bitcoin reserve worth about $3 billion. If the price of UST becomes less than $1, the reserves are sold and UST is bought with the money received. If the price of UST becomes more than $1, the team sells UST, bringing the stablecoin back to $1. The profit from the sale of UST is then used to increase reserves.

Everything seems to be well thought out and should work, but today the price of UST is 6 cents, and one Luna isn’t even a cent. How could this happen?

To the most interesting part: how did Luna and UST get into the ‘death spiral’?

It all started on Saturday, May 7. UST worth more than $2 billion was withdrawn from the Anchor Protocol staking. A significant portion of this amount was sold, causing UST to fall to 90 cents. Market participants attempted to take advantage of the arbitrage opportunity and exchange UST worth 90 cents for the US$1 equivalent of Luna. The problem arose when the volume of UST for sale began to exceed the allowable limit of “burning” Luna in one day. Luna tokens can be burned for a maximum of 100 million UST in a 24-hour period.

After the loss of the UST dollar peg, investors, already frightened of the “bloody” market, rushed to sell UST. Panic sale began. Within a week after the initial fall, the UST exchange rate was between 30 and 50 cents. At the time of writing, UST is at 6 cents.

Luna holders have found themselves in an even more unfortunate position. Today, 1 Luna token can be sold for $0.00015. Such a price is catastrophic when you consider that the value of Luna was as high as $116 per coin.

No one knows the exact reason for such a dramatic outcome for Terra. Perhaps it was a coincidence and, as it turned out, 100% insecure mechanics, or perhaps a perfectly planned attack on the project. It doesn’t really matter what the cause was. If there is a possibility of such an outcome, it says that the system is unsafe and needs to be improved. And the worst part is that it can happen to even the most robust project.

And in conclusion

The Terra Luna tragedy should forever be a reminder in the mind of every developer and founder of every crypto project. Safety systems and mechanics of securing network assets must be strengthened on an ongoing basis. For us this case was another reason to test and make sure how confident we can be about the reliability of the EYWA project. To stay up to date with new articles and events related to our project, follow EYWA’s social networks!