Crypto News
12 May 2022

Unpacking the Terra Crash, and What’s Next for the Stablecoin

Ananda Banerjee

The largest algorithmic stablecoin, TerraUSD (UST), is on a downward spiral. And so is its sister coin, LUNA. Is this the beginning of the end of Terra, or a storm it will get through to emerge stronger?

What are UST and LUNA?

LUNA and UST are the two native coins of the Terra network. UST is a stablecoin, which is to say its value is pegged to a currency, commodity or financial instrument. In this case, 1 UST = 1 US Dollar. That’s the goal, at least.

“Traditional” stablecoins achieve this peg by holding equivalent amounts of dollars. UST achieves this peg by engineering the supply and demand of the coin with an algorithm. Here’s where LUNA comes in.

If UST’s value falls below $1, traders are incentivized to swap 1 UST with LUNA equivalent to $1. And that UST is “burned”, reducing the supply of the stablecoin, and stabilizing it back $1. If UST goes above $1, LUNA holders are incentivized to swap it with newly minted UST, while the LUNA is burned. This increases the supply of UST, stabilizing the value back to $1.

Well, that’s the theory.

So, then, what happened?

Simply put, UST de-pegged. It fell below $1 due to large-scale selling. And the swapping mechanism with LUNA has so far failed to stabilize it. And because more and more LUNA are being sold to reduce UST’s supply—burn—in an attempt to stabilize it, LUNA has nosedived, too. More on how exactly happens in the next section.

How bad is it? At the time of writing this, UST was trading for $0.6. LUNA was trading for $0.5145, having fallen over 95% in a day. The two coins have combined lost a market cap of $40 billion.

But how? Let’s dive deeper

Remember, the supply and demand? Why was there a demand for UST? Terraform Labs, the creators of Terra network, and the Luna Foundation Guard, a consortium, are building an ecosystem that would create utility for the stablecoin. For instance, investors use stablecoins to buy other Cryptos and as a safety haven during market turbulence.

But, the largest demand-creator for UST is a liquidity pool called Anchor. Traders could deposit UST in Anchor and get returns of as high as 20%! So traders did just that. But that interest rate, or yield, was not sustainable. Anchor had announced it would gradually lower the yield.

Here is a timeline to explain why Terra is bleeding:

  • LUNA was shorted across exchanges, increasing the supply of UST. (FYI: Shorting is a strategy used by traders who anticipate the value of an asset to fall. In general, they borrow the asset and sell it in the market, and then buy it back when the value drops and return the asset to the lender while pocketing the profits)
  • Anchor protocol announced that the yield will be reduced to 18%, from 19.4%. This resulted in UST sell-offs, since holding UST isn’t as profitable as before.
  • Panic spread on social media, with the news of UST de-pegging. The FUD, or Fear-Greed-Uncertainty, caused more selloffs.
  • The increase in the supply of LUNA and the dumping of UST crashed the price of these coins.

Didn’t Terra anticipate this?

Yes, and No.

To prevent worse-case scenarios, the Luna Foundation Guard had been buying and holding bitcoin (BTC). The idea is, if and when the algorithm-based swapping mechanism of UST and LUNA fails to maintain the peg, LFG will step in and buy UST from the market and sell BTC.

Do Kwon, the developer and the founder of Terraform Labs, had previously committed to buying as much as $10 billion worth of Bitcoin as a backstop. That is still only a fraction of the nearly 18 billion UST in circulation.

Further, with BTC losing value for the sixth consecutive week, Terra’s reserves started to go deep into the red—triggering panic selling of UST and LUNA.

The de-pegging of UST is not the first such turbulence to hit algo-stablecoins. In 2021, IRON, a partially collateralized algorithmic stablecoin, de-pegged, and its sister coin, TITAN, crashed from $60 to near $0 in a matter of hours as large whales dumped the asset. Even billionaire investor Mark Cuban was caught in the storm. Cuban didn’t reveal the dollar value of his loss but told Bloomberg: “It was enough that I wasn’t happy about it.”

LUNA daily chart

LUNA Daily Chart (Noticeable Dip and Increased Trading Volume/Active Sellers)

Source: Trading View

Disclaimer: Insights mentioned are time-sensitive and should not be considered as financial advice. Please DYOR (Do-Your-Own-Research).

The Future of UST

This is TBD. But here’s what they’re doing to stabilize it.

Luna Foundation is in talks with large investors to raise funds to arrest the slide and restore the peg. Here’s the plan:

  • Absorb UST supply by introducing a lock-in period of sorts
  • Raise funds worth $1.5 Billion or more to buy UST and strangle the supply
  • Cap daily UST selling
  • Increase the minting speed of LUNA to use it for absorbing UST. (More LUNA in the ecosystem)
  • Get investors to move back to the Anchor Protocol

A consequence is LUNA supply will drastically increase, reducing its value.

Terra Restoration

What of Other Stablecoins?

As far as other stablecoins are concerned, things look steady. USD Coin, or USDC, and True USD are pegged to the dollar with actual reserves. DAI, the decentralized stablecoin by MakerDAO, is over-collateralized. In fact, DAI has now leapfrogged UST as the fourth-largest stablecoin by market capitalization. But USDT, or Tether, has come under pressure and de-pegged to $0.95 before a brief recovery at the time of writing. This is more or less everything you need to know about Terra’s meltdown.

With the BTC being increasingly exposed to Terra’s ecosystem—through the reserve—the headwinds have disrupted the entire market. Not that Terra’s crash is the only reason for the broader market downtrend.

Net-Net, UST has had a rough seven days with prices touching as low as $0.29—on the 11th of May. And LUNA holders have been hit hard in the turmoil. The road ahead depends on how quickly Terraform Labs can implement the turnaround plan.

And as an investor, trader, or HODLer, this might just be the right time to make sure you DYOR over anything else.

Disclaimer : Crypto products and NFTs are unregulated and can be highly risky. There may be no regulatory recourse for any loss from such transactions. The information provided in this post is not to be considered as investment/financial advice from CoinSwitch. Any action taken upon the information shall be at user's own risk.

writer

Ananda Banerjee

Content Writer

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