Why did TerraUSD and Luna Crashed? Here’s Why We Need to Know about Algorithmic Stablecoins

Terra UST once took over BUSD to become the third-largest stablecoin with an 18.73 billion market cap at its peak.

 

Key Takeaways

  • TerraUSD (UST), one of the most popular algorithmic stablecoins crashed resulting in a sharp drop in its price from a $1 peg to $0.30 on May 11, 2022. Amidst the chaos, TerraUSD’s sister token Luna also sank to a near-zero figure.

  • Algorithmic stablecoins value is not tied to any reserve or assets like gold or fiat currency. It uses a blockchain algorithm to balance its value.

  • TerraUSD is backed by computer algorithms that maintain the balance of market demand and supply of tokens

Explore these article sections

Introduction

TerraUSD (UST), one of the most popular algorithmic stablecoins crashed resulting in a sharp drop in its price from a $1 peg to $0.30 on May 11, 2022, which crippled almost the entire crypto market. It was one of the most shocking news that spread like wildfire.


Coinmarketcap chart of UST

Source: Coinmarketcap


Stablecoins are pegged with the US dollar in the one-is-to-one ratio, and the sudden slip in the price was a wake-up call for many crypto enthusiasts and investors. It has inevitably shaken the confidence of many investors and left many critics and analysts wondering is it worth investing in stablecoins or is it a risky affair?


It has been a crazy week for crypto lovers. Amidst the chaos, TerraUSD’s sister token Luna also sank to a near-zero figure. It was terrible news for many investors who lost almost all of their savings. Many first-timers were confused about what was going on as there were several theories circulating in the market.


So, what really happened?


Why did TerraUSD and Luna Crash Here's why We Need to Know about Algorithmic Stablecoins Luna 2.0 icon

Understanding TerraUSD (UST)

TerraUSD or UST is one of the most popular algorithmic stablecoins that was developed by Terraform Labs, which was founded by Do Kwon, a South Korean crypto developer. For those, who are not familiar with algorithmic stablecoins, their value is not tied to any reserve or asset, such as gold or fiat currency. Instead, a blockchain algorithm is used to balance its value.


How Does Terra's Algorithmic Stablecoin Work?

How does Terra Algorithmic Stablecoin Work?

The blockchain algorithm maintains the dollar-peg ratio. UST is tied to its sister token Luna, both created by Terraform Lab. The LFG or Luna Foundation Guard was founded to safeguard the UST peg and is responsible for maintaining this balance. For every minting of UST token, an equivalent monetary amount of Luna is burnt.


1 UST can always be used to swap for $1 worth of Luna and vice versa for $1 worth of Luna on the Terra Station Market Module.


When the UST price is above $1

Arbitrage traders would buy Luna and swap it for UST, since $1 worth of Luna can always swap for 1 UST, they would be getting UST below the current price. After swapping, they can sell the UST immediately for a risk-free trade causing a selling pressure and decreasing the price.


When Luna is swapped for UST on Terra Station Market Module, the algorithm would burn the Luna and mint new UST and this would dilute the UST supply hence causing its price to decrease further.


When UST price is below $1

Arbitrage traders would buy UST and swap it for Luna, since 1 UST can always swap for $1 worth of Luna, they would be getting Luna at a discount. After swapping, they can sell the Luna immediately for a risk-free trade. The buying pressure of UST would therefore increase the price.


When UST is swapped for Luna on Terra Station Market Module, the algorithm would burn the UST in exchange for LUNA and this would decrease the UST supply hence causing its price to increase further.


What happened to Terra’s UST?

What actually happened on Terra UST?

On Saturday, May 7th, the de-peg began. Terraform Labs' withdrawal of $150 million UST from the Curve Wormhole pool to prepare for the 4pool launch sparked it. This was followed by a massive $350 million sell of UST for USDC on Curve, causing a significant imbalance in the pool between the UST (85%) and 3CRV (15%). This caused a de-pegging event and as a result, there was a bank run on Anchor, with users frantically withdrawing their funds and swapping out of UST. This selling pressure on UST triggered a "death spiral," a reflexive downwards spiral.


UST's collapse also brought down its sister token Luna. But what is causing this sudden fall in Luna prices?


Because of the algorithmic nature, arbitrageurs can buy UST tokens at a price lower than $1, redeem UST for $1 worth of LUNA, and sell them immediately, causing its price to plummet. Due to the supply dilution, the price would continue to drop, and this would cause more LUNA to be minted for each UST burned, resulting in a hyper-inflationary loop in LUNA's supply.


There are also other conspiracy theories that were circulating the market. A Twitter thread revealed that the $350 million UST sell-off was an attempt by an anonymous attacker who deliberately dumped UST to bring down the price of $1 peg, and it may have forced LPG to sell off its reserve of Bitcoins to save UST. Presumably, the attacker has made an enormous profit of $800 million off shorting Bitcoin. The matter is still under investigation and is yet to be proved whether the attack was true or just speculation.


What can we learn from the UST crash?

Fortunately, since UST and Luna are still in their infancy, they did not cause a major crisis in the DeFi market worldwide. But still, there have been massive losses amounting to $40 billion.

  • There is no such thing as a 100% safe asset (yet), and large projects fail as well.

  • Because crashes tend to happen quickly, the market may not give you enough time to close your positions.

  • Keep a diversified portfolio and take profits along the way.

  • Partners, venture capital funds, and major investors are not as important as you think.

  • In times of crisis, the actual value of digital assets may be revealed.

What’s next for Terra?

After the unprecedented crash of the entire market cap, Terraform Labs co-founder Do Kwon came up with a new proposal to revive the Terra economy. On May 18, they announced a new governance protocol to fork the old Terra blockchain. The new Luna blockchain went live on 28 May 2022. It will not be associated with the TerraUSD stablecoin. Meanwhile, the previous Terra blockchain will continue to be linked to UST and will be renamed TerraClassicUSD (USTC) and Terra Classic (LUNC). According to the plan, it will airdrop new Luna tokens to UST and LUNC holders and other developers of the Terra ecosystem.


Do Kwon believes that it is impossible to recover the loss at this point as much of its DAO Reserve was lost to de-peg UST. However, they are still looking for external resources and funders to support Terra community members. Will the Crypto community trust Do Kwon again? Will the new LUNA have any value without its counterpart, UST?