Why Did Terra Luna Crash?

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LUNA, the native cryptocurrency of the Terra Ecosystem, has fallen over 99.9% since it crashed. Previously a top 10 token by market capitalization, LUNA is currently ranked around #100 worldwide. 

The following discussion will explain what caused the crash and what you need to know about the Terra Protocol going forward.

What Does Terra Do?

Terra is a blockchain network that specializes in stablecoin creation. The network was founded in 2018 by Do Kwon and Daniel Shin of Terraform Labs. Terra provides smart contract capability for the creation of a wide range of different stablecoins. The project has stablecoins pegged to the U.S. dollar, South Korean won and euro, among others. 

Tokens in Terra’s ecosystem are represented by two token types: LUNA and a family of Terra stablecoins on the blockchain.

What is UST?

UST is an algorithmic stablecoin in the Terra ecosystem, so unlike fiat-backed stablecoins such as USDC and BUSD, UST is not backed by real assets. Instead, the value of UST is backed by a sister token called LUNA and relies on algorithms to maintain its $1 peg. 

When UST's price rises too high, its algorithms mint more LUNA to lower its price — or the reverse if the price falls too low. LUNA is meant to serve as a kind of shock absorber for UST's price. For this stabilizing price mechanism to work, users can redeem 1 UST for $1 worth of LUNA, even if UST is worth less than $1.

Stablecoins are like safe havens in the cryptocurrency ecosystem. In theory, they are meant to have a fixed value of around $1 USD so they can be a reliable store of value for investors in contrast to extreme volatility of Ethereum, Bitcoin and others. 

All stablecoins require utility to maintain demand and defend their peg; otherwise, what's the point of holding a stablecoin as opposed to fiat? UST gets its utility from Anchor Protocol — a decentralized finance (DeFi) application that aims to pay 19.5% APY to stake UST.

What is LUNA?

LUNA is Terra’s native token and plays four different roles in the Terra Protocol:

• A mechanism to absorb demand fluctuations for stablecoins minted on Terra to maintain price pegs
• A method to pay transaction fees in the Terra network
• A way to take part in the platform’s governance system by creating and voting on proposals regarding changes to the Terra Protocol
• Staked in Terra’s delegated proof-of-stake (DPoS) consensus mechanism to facilitate the validation of network transactions 

Why Did LUNA Crash?

Before the collapse, over $2 billion worth of UST was unstaked (taken out of Anchor Protocol), and hundreds of millions of that was immediately sold. Whether this action was in response to a particularly volatile period, the fact that rising interest rates had affected the broader cryptocurrency market or a malicious attack on Terra’s ecosystem is an ongoing topic of debate. 

Nonetheless, this huge selling pressure initially pushed the price of UST down to 91 cents. Of course, the bottom fell out of the currency, and it now sits well below a penny.

Why Was This a Problem?

Users can always redeem 1 UST for $1 worth of LUNA, even if UST is worth less than $1; a condition necessary for the price stabilizing mechanism of UST. 

As a result, many traders tried to take advantage of arbitrage, exchanging 90 cents of UST for $1 worth of LUNA. 

How Does This Affect LUNA?

The collapse of LUNA and UST go hand in hand; however, before deep diving into this collapse, some context surrounding LUNA is needed.

Bearish sentiment in the broader crypto market resulted in LUNA's price, like many other altcoins, crashing over the last few weeks, essentially putting the market capitalization for LUNA below that of UST’s. 

This situation caused a huge problem because it meant that the average redemption price of LUNA for UST was high relative to LUNA's current price. In other words, the amount of LUNA that needed to be sold in return for UST drastically increased. 

To better illustrate this, refer to the following example:

Let’s say the price of LUNA is $1 million. This means that someone could mint 1 million UST by burning a single LUNA. Next, let’s imagine the price of LUNA falls to $1 for no good reason. This means that someone could now redeem their UST for 1 million LUNA.

Well, herein lies the problem: the longer UST remains de-pegged and the more it de-pegs to the downside versus the U.S. dollar, the more pressure LUNA will come under as arbitrageurs seek to make a quick buck.

Nonetheless, this caused LUNA’s market cap to continue to fall relative to UST’s market cap, further exacerbating the already high average redemption price of LUNA for UST, and the implications that come with it. 

The Death Spiral

With UST depegged and an increasing amount of LUNA dumped on the open market, fear that there wouldn't be enough funds in the Terra project to properly back the value of UST magnified. This further increased the selling pressure on LUNA.

As a result, the liquidation of Terra-native digital assets was far quicker than the algorithmic stabilizer could take effect.

In response, the LUNA Foundation Guard (LFG) depleted all its reserve assets in an heroic effort to further boost the value of UST; however, the effort ultimately failed, resulting in LUNA tanking and losing virtually all its value in a matter of days.

Will LUNA Recover?

The token has the potential to recover, but at present, things are extremely uncertain. At the time of writing, LUNA has been delisted from many major crypto exchanges including Binance and OKX. Moreover, operators have repeatedly halted the Terra blockchain because of security concerns.

In the aftermath of the Terra ecosystem collapse, many developers, communities, investors and families have been devastated — some individuals lost their life savings and rumors have circulated that as many as eight traders took their own lives.

Additionally, crypto information sites like CoinMarket Cap are warning investors that the token is extremely volatile and has already lost over 99% of its value.

Nonetheless, the situation surrounding UST and LUNA reinforces the risk of algorithmic stablecoins and the importance of diversification in the digital investing industry. The founder of Terra Protocol, Do Kwon, recently released a revival plan which can be viewed here.

See also: How to Buy Terra Luna

Cryptocurrency Market Outlook

Looking ahead, it may take some time for the broader cryptocurrency market to heal from the Terra Ecosystem collapse. Despite setbacks, the crypto community is still learning and innovating. Events such as the fall of UST act as key lessons for the budding industry that may allow for the creation of more secure and stable crypto projects moving forward. 

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