Why Did Luna Crash?


The cryptocurrency market is seeing one of its worst selloffs since a market rally in 2020. The total crypto market cap is down 28% from a week ago at $1.2 trillion amid a broader meltdown. Cryptocurrencies slumped further Thursday and have lost more than $500 billion in market capitalization since last week. That $500 billion loss is more than some GDP of developed countries such as New Zealand which has a GDP worth 215 Billion USD or Developing counties such as Singapore which has a GDP worth 425 Billion USD.


The loss in the cryptocurrency market has two main reasons, a macro one which is raising interest rates by the central banks that absorb the liquidity from the highest risk market, and the second reason is a micro one and which was the collapse of the second-largest stable coins Terra USD (UST).


What is a stable coin? It is a type of cryptocurrency that is supposed to have a stable value as its name suggests because the tokens are pegged to the value of a currency such as the U.S. dollar providing relative insulation from extreme volatility. Collateralized stable coins are pegged to another asset like the U.S. dollar, and their issuers say they back up the value of their coin by holding on to that asset or something similarly safe. Other stable coins are pegged to the price of crypto assets such as Ether or, in certain Defi (decentralized finance) apps, collections of coins put up as collateral. Some employ algorithms to manage supply and demand, and therefore value. The largest market cap of stable coin cryptocurrencies is the Tether coin called USDT and Terra USD coin is called UST; both of these coins are pegged to the US dollar and every coin equal 1$. Stable coins are very popular because they can be a bridge between two worlds, cryptocurrencies and traditional finance. They also make it easier to move funds into crypto exchanges. Many exchanges do not have the relationships with banks needed to offer regular currency deposits or withdrawals, but can and do accept stable coins


Last week, UST crashed from its dollar peg and is trading now around 0.177 USD for every 1 UST leaving traders in a lot of pain, so how did that happen to a coin that should be a stable coin?


Terra USD or UST is an algorithmic stable coin meaning it uses a complex combination of codes, trader incentives, smart contracts and a little bit of faith to maintain its peg of one-to-one to the dollar. It does this by working with a crypto token in the same ecosystem called Luna which can be swapped for UST and vice versa by traders to keep the price of UST where it should be. UST founders promise that people can always exchange one UST for $1 worth of Luna. If Luna trades at $0.10, then one UST will get you 10 Luna. If Luna trades at $20, then one UST will get you 0.05 Luna. Doesn’t matter. The price of Luna is arbitrary, but one UST always gets you $1 worth of Luna. (And vice versa: People can always exchange $1 worth of Luna for one Terra.)


The point of projects like the UST is to enable crypto traders to make transactions easily and quickly without needing to leave the digital asset ecosystem, rely on intermediaries or worry about the value of their coins going up and down.


The algorithm crashed from its dollar peg when the complex mechanism designed to ensure the link suddenly turned against it, sucking even the biggest digital assets into a vortex of panicked selling. Terms like “death spiral” entered the vernacular. Almost $45 billion evaporated from the market caps of Terra USD (known as UST) and Luna over the course of a week, according to Coin Gecko.


“It was inevitable Terra crashed as the reliance on using other cryptocurrencies as collateral as well as the minting/burning mechanism of LUNA for Terra was not sufficient to survive any serious market volatility,” says Adam Carlton, CEO of crypto wallet Pink Panda says. In a bid to save TerraUSD, the Luna Foundation Guard (LFG), the nonprofit that supports the Terra network, depleted its entire reserve of $3 billion in Bitcoin this week. And it was the fund’s dumping of its Bitcoin reserves in a last-ditch effort to save UST that probably helped contribute to Bitcoin’s volatility.


Luna reached an all-time high of $119 only last month. Its fall has been quick and fast, leaving the wider crypto community at a loss for how this might impact the broader ecosystem. According to Bloomberg Intelligence, Luna’s sharp value decline looked like the worst day for a financial product ever seen and it prompted cryptocurrency exchanges to delist the coin, bringing its trade to a halt as there was no liquidity in the market.


Coinbase stock slumped 35% this week and ended the week with a market value of $15 billion. On Thursday, Bitcoin hit a 52-week low, slumping to $25,402, a level not seen since December 2020. The “digital gold” has since rebounded but, at the time of this writing, it bounced up above $30,000.


The people behind Terra include Terraform Labs, the entity that created it, and Do Kwon, the South Korean entrepreneur and “King of the Lunatics” who founded Terraform. There is also the Luna Foundation Guard (LFG), an entity run by Kwon and others that tries to defend the UST peg to the dollar. They are working on solutions.


Kwon tweeted a thread announcing his plan to fix things. One element of the plan is to issue a lot more Luna, so that one Terra can reliably be exchanged for $1 worth of Luna, even if that means bazillions of Luna. The proposal would print Luna faster to clear out the backlog allowing more efficient UST burning and LUNA minting. It will also, in the short term, put pressure on LUNA’s price, but will be an effective way to bring UST back to peg, which will eventually stabilize LUNA’s price.  Yes, billions of UST will be burned, and LUNA will be diluted significantly. Nevertheless, there is no limit in LUNA supply, this market mechanism will actually work to bring stable UST and stable LUNA price (although likely at lower price point for LUNA)


Another solution is for LFG to step into the market and buy enormous amounts of Terra to stabilize the price. To do this, you need money (Or Bitcoin, or Ether, etc.) As we have discussed, Kwon actually prepared for this possibility; that’s effectively what the Luna Foundation Guard is. When times were good — when Terra was popular and Luna was valuable — the LFG printed a bunch of valuable Luna and used them to buy a lot of Bitcoins. And so, this week LFG had a lot of Bitcoins, and could use them to buy Terra in the market. (Or, equivalently and more intuitively, sell the Bitcoins for dollars and use the dollars to buy Terra.) This propped up the price of Terra, but it has some disadvantages. One disadvantage is that LFG is selling a bunch of Bitcoin, bringing down the price of Bitcoin.


Terraform Labs, which created the Terra blockchain where Luna and UST were born, is backed by some of the deepest pockets in the industry, including Coinbase Ventures, Galaxy Digital and a host of others. Yet skepticism is rampant that Terra will be able to line up enough financing to save its stable coin from a death spiral.


Treasury Secretary Janet Yellen gave the US government’s most forceful response yet to the meltdown of Terra USD, saying that the crypto stable coin’s woes underscore the risks associated with the asset class. Yellen said on Thursday that Terra’s spectacular tumble shows the dangers of tokens that purport to be pegged to the US dollar. She called for new regulations and added that Treasury was working on a report about the issue.


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