The cryptocurrency world was vigorously shaken over the past week and a half as the Terra blockchain and its native tokens, UST and Terra LUNA, plummeted. It all started when the blockchain’s stablecoin, UST, was depegged from the United States dollar.
The depegging set in motion a series of events that resulted in UST plummeting to $0.09, a far cry from being always worth US$1 as designed. Its sister coin, LUNA, took an even more intense nose dive, going from US$82 on May 5th to$0.0001523 at the time of this writing.
As of now, the Terra blockchain has been halted as the developers come up with a recovery plan.
Investors who believed in Terra have lost entire fortunes, with stories being posted across social media of the real-world impact of this significant drop in value. Terra developers are working hard to repeg UST to the dollar, but many worry there’s no coming back from this level of devastation.
Today, we’ll explain the collapse of the popular stablecoin and its sister coin to explore what this means for investors and the overall crypto space. Read on to learn everything you need to know about this significant event.
Understanding the Major Players in Terra’s Collapse
Before diving deeper into what happened to Terra, we need to understand how the blockchain and its tokens operated in ideal conditions. There were three major players involved in the collapse and rapid devaluation of the tokens; let’s discuss them.
UST and LUNA: An Algorithm Instead of Collateral
Stablecoins are a specific category of cryptocurrency that is designed to always equal a specific fiat currency, most commonly the United States Dollar. In addition, most stablecoins are collateralized in some way to ensure their consistent value, such as USDT, USDC, BUSD, and DAI.
UST is a different breed of stablecoin, an algorithmic stablecoin. Rather than representing a pool of resources, such as a stash of USD, it maintained its value by betting on traders taking advantage of arbitrage opportunities.
Arbitrage opportunities are everywhere in cryptocurrency markets. Traditionally, it’s when one platform has a higher or lower price for a coin than another platform. For example, if you buy Bitcoin on one exchange for $29,000 and then sell it on another exchange where the current price is $29,500, you make a low-risk profit, which can add up with a high enough volume.
So, UST’s entire premise was that traders would always take advantage of a low-risk profit. UST and LUNA Terra could be traded for one another at a guaranteed rate of $1. If the UST price slipped to $0.99, traders could burn (permanently destroy) LUNA tokens at a rate of $1 per UST. Traders would then make a guaranteed profit of $0.01 per newly minted UST.
It worked in both directions, with 1 UST always being worth $1 of LUNA. More LUNA would be created if necessary to ensure this consistent price (this is important to what went wrong).
Terra and the Anchor Protocol
Terra is the name of the blockchain and network that operates both UST and LUNA. LUNA is the specific token minted during its proof-of-stake mining, with UST being created by burning LUNA for it. In other words, LUNA is to Terra what BTC is to the Bitcoin blockchain.
Terra itself operates over 100 various projects, including DeFi platforms, NFT collections, and web3 applications.
Anchor is one such DeFi platform built on Terra by Terraform Labs. It became wildly popular by offering 20% APY on staked UST, a stark contrast to the 0.05% or less than many fiat savings accounts offer. This massive APY led to the rapid adoption of the Anchor Protocol and supported LUNA’s price climb from under $1 in early 2021 to $84 by the end of 2021.
Curve Finance: A Stablecoin Liquidity Pool
Curve Finance is a liquidity pool focused on stablecoins and represents a way for UST holders to trade the stablecoin for another stablecoin, such as DAI or USDT.
Like the UST/LUNA relationship, Curve allowed traders to capitalize on discounted stablecoins if the pool became too saturated with one of them. For example, if DAI slipped to $0.98, someone could trade UST worth $1 for DAI and make a $0.02 profit, which is significant with enough volume.
Curve offered discounted rates if it had too many of a specific stablecoin. It would intentionally drop the price of high volume stablecoins to incentivize holders of in-demand stablecoins to trade them.
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Where Things Went Wrong: The $2 Billion Unstaking
We’ve previously discussed how stablecoins are the lowest-risk way to invest in crypto. However, UST’s algorithmic method of maintaining stability was experimental and has received widespread criticism throughout its life.
On Saturday, May 7th, 2022, approximately US$2 billion was unstaked from the Anchor Protocol, with hundreds of millions of that amount being immediately sold. This massive movement may have been an honest reaction to overall market conditions, but plenty of conspiracy theories related to intentional manipulation have taken root (we’ll discuss this more later).
The massive sell-off pushed the price of UST to $0.91. Traders moved to capitalize on this, as designed, by trading 90-cents of UST for $1 of LUNA. However, there was a problem – only $100 million of UST can be burned per day on Anchor. That limit was hit before the stablecoin could regain stability.
Traders flocked to Curve Finance, among other platforms and exchanges, to offload their UST. Curve’s liquidity pool became unbalanced and made the price even more unstable.
Every day since the 7th, people burned UST for LUNA, resulting in the hyperinflation of LUNA. The Terra LUNA price was in freefall, and nobody wanted to burn their LUNA for UST as it tanked in value – the entire system fell apart.
Several exchanges paused trading and withdrawals for both tokens in an effort to prevent its further collapse, but it was too little, too late.
The price of UST jumped between 30 cents and 50 cents for a few days but kept dropping. The Luna Foundation Guard, formed by the developers of Terra to protect the stablecoin, sold off Bitcoin and other assets held in reserve to try to regain stability, but every attempt only provided temporary relief.
A thread posted on May 16th by the Luna Foundation Guard detailed its reserve holdings, which have come under intense scrutiny since this all began, and stated how and when the holdings were used. Bitcoin was sold for 1.5 billion UST, while USDT and USDC were traded for 50 million UST. An additional trade by the makers of Anchor exchanged 33,206 Bitcoin for 1.1 billion UST. It remains to be seen if this report will satisfy the many skeptics of Terra’s holdings and how they were used.
Remember how new LUNA is created if necessary to satisfy UST burning? That resulted in hyperinflation that crypto was originally designed to avoid. The present supply of LUNA is 6.9 trillion, up from 345 million on May 10th. That’s a supply increase of 1,903,664.72%.
With the Terra blockchain halted and trading still paused on many platforms, the future of Terra and its experimental stablecoin remains uncertain. The developers continue to assure investors, but the damage done to the stablecoin will be hard to repair. Even if they can repeg it to a dollar, the damage to its reputation isn’t going anywhere. What about
Was Terra Intentionally Attacked?
Cryptocurrencies will always be subject to attack, whether exploiting a weakness or targeting developers with social engineering attempts.
Terra banked on honest market movements by investors looking to make a profit on arbitrage opportunities and high APYs. However, the unique algorithmic stablecoin didn’t think about someone with billions of dollars suddenly withdrawing and selling assets.
A popular Twitter thread has become the center of a theory that an unknown wealthy investor aimed to short Bitcoin by attacking Terra. The general theory is that the Luna Foundation Guard had begun buying more significant amounts of Bitcoin for its reserve. The attacker aimed to destabilize UST to force the developers to sell its hordered Bitcoin, dropping its price. The thread concludes by estimating the attacker gained US$800 million.
Tether, another stablecoin impacted by the Terra LUNA coin collapse, told Fortune it is investigating the transactions that preceded the event. The representative says that independent investigators are undoubtedly on the case, and hopefully, the following weeks will provide some clarity into what transpired.
What’s the Damage Caused by Terra?
Terra’s meltdown affected the entire crypto space. In our recent price analysis, we examined the impact of Terra rippled throughout the market. Bitcoin shows impressive resilience amid Terra’s collapse despite temporary drops in value.
Investors who went all-in on Terra have experienced a worse situation than the 2008 recession, with all of their value evaporating in a week. Reports have been posted on every social media platform from first-time investors losing their life savings, primarily drawn in by the 20% APY and easy arbitrage profits.
Additionally, a Bloomberg analyst discusses how as cryptocurrency becomes more intertwined with traditional markets, events like this will have far-reaching consequences outside of the crypto space. For example, traditional investors who lost money on Terra’s coins are unlikely to buy more stocks the next day.
What about a Terra LUNA price prediction? The burning mechanism built into the system creates a way for the new massive supply to decrease, but that will rely on investors taking a loss or the developers implementing an added incentive. The price of LUNA may collapse further, or recover – it all depends on how the developers and market react from here.
What Can Investors Learn from the Terra Collapse?
Terra exemplifies the old adage, “If it’s too good to be true, it probably is.” Terra promised investors low-risk profits and massive APYs. There was no downside, luring investors, both old and new, to the blockchain’s algorithmic stablecoin and its sister coin, LUNA.
Investors from traditional markets already know the importance of diversification, and Terra shows us why. If Terra’s coins made up 3% of an investor’s portfolio, its collapse wasn’t devastating. However, newer investors took their nest eggs out of savings accounts to instead earn 20% APY on them or leverage them for low-risk arbitrage profits from the UST/LUNA relationship.
The lesson from Terra is largely for blockchain developers – what happens if someone with billions of dollars tries to exploit your platform? Unfortunately, blockchains and DeFi platforms cannot expect everyone to play fair.
What can investors learn from Terra? Diversification and research.
The Terra blockchain and its coins depended on investors always wanting to trade the two coins, but we saw what happened when that belief fell apart. Thoroughly researching the Terra stablecoin would’ve likely raised some red flags for many investors. Additionally, it’s important to understand that DeFi is relatively new, and all DeFi platforms should be considered risky.
The right platform that thoroughly vets new coins before making them available to its investors is vital to protecting your assets. Coinmotion conducts intensive research on every cryptocurrency before making it available to our investors, adding an extra layer of protection between you and questionable assets. Set up an account with Coinmotion today to help safely build your crypto portfolio.
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