Simplifying What Happened to the Terra Luna Crypto Crash

2022-05-13 , 2:54 pm

Cryptocurrency genuinely deserves the name it has.

For the layman, the digital currency seems out of reach and hard to decipher with all the difficult jargon being thrown around.

For instance, why does cryptocurrency have to be “mined”? How does the blockchain system work? How does cryptocurrency decentralise finance and why are there so many types of digital currencies, ranging from trollish ones like the Dogecoin, to the much debated and ever-fluctuating Bitcoin?

In the spirit of goodwill, here’s what happened in the Terra Luna Crypto Crash simplified for you.

What is Terra Luna?

Firstly, it is important to know what Terra Luna is, before we get into the detail of how it failed, and what its far-reaching consequences are.

Terra is a blockchain that is powered by two cryptocurrencies concurrently: namely Terra and Luna.

Terra is a Stablecoin, which means it is tied or pegged to a fiat currency—money that a government guarantees as its legal tender—for the main purpose of stability.

For example, the TerraUSD is tied to the US dollar. Therefore, 1 TerraUSD is supposed to always translate to 1 US Dollar, and vice versa.

However, all currencies are prone to some form of volatility, whether it’s inflation or deflation due to either an increase/decrease in demand or increase/lack of supply.

This is where Luna comes in: the existence of this cryptocurrency is to absorb the stablecoin price volatility.

Readers: Hold on, how that even work?

Well, the answer is both simple and complex, but bear with me.

The Terra stablecoin maintains its price through a built-in arbitrage system, and arbitrage is the simultaneous buying and selling of an asset to capitalise on small price discrepancies in different markets.

Let’s say the demand for TerraUSD drives its price up to $1.02. To restore its equilibrium, which is to bring it back down to $1, the blockchain will allow traders to burn $1 worth of Luna to mint one TerraUSD coin.

The trader can then sell that TerraUSD coin to earn a profit of $0.02. At the same time, it increases the supply of the TerraUSD, which eventually brings its price down back to $1.

Similarly, if the TerraUSD is valued at $0.98, the blockchain will allow traders to burn one TerraUSD coin to mint $1 worth of Luna. The trader will make a profit of $0.02 again, while the arbitrage system restores the peg, increasing the price of TerraUSD by reducing the supply.

If this explanation still doesn’t make sense, think about the ART kit price problem that we had to deal with during the Omicron wave months ago.

When no one really needed the ART kits, the prices remained relatively cheap and affordable.

But when there was a surge in demand for the ART kits because of the Omicron wave, which led to a lack of supply, the prices were driven up due to its scarcity.

In response, the government released its own ART kit reserves to the sellers, which brought the price of an ART kit back down again.

In this case, the government is the “Luna” of ART kits, whose main goal is to ensure the prices are stable by keeping an eye on and controlling the supply directly/indirectly.

Benefits and Types of Stablecoins

The reason why Stablecoins are one of the most popular types of cryptocurrencies is literally in its name. It’s stable and thereby safer to invest in.

The advent of cryptocurrency in the first place was to decentralise finance, ergo instead of having to go through banks to make transactions, people can conduct peer-to-peer payments through the blockchain technology.

The benefits of blockchain technology are that every transaction made must be mutually consented by both parties before it can occur, and it will always leave a digital record.

This record is unchangeable and inherently resistant to modification due to the cryptographic methods of the blockchain structure data.

Because blockchain technology has no single point of control since it functions on a network of distributed and decentralised nodes, transactions made are more secure and it is highly resilient to subversion or alterations.

The next thing you need to understand about Stablecoins is that there are two types: a fiat-backed stablecoin and an algorithmic stablecoin.

A fiat-backed stablecoin like the USD Coin is supported by cash and cash equivalents. In essence, for every USD Coin in circulation, there will be one real dollar (or its equivalent) held in a reserve account.

Whereas an algorithmic stablecoin like Terra is dependent on an arbitrage system, namely its “sister” token Luna, which runs on pre-programmed smart contracts, in order to maintain its peg and stability.

Since fiat-backed stablecoins are reliant on government-issued money, it is significantly more stable because a government is unlikely to make drastic fiscal decisions that will affect the valuation of their own currency.

In contrast, algorithmic stablecoins pose a higher risk, because should the arbitrage mechanism fail to resolve the problem and restore the equilibrium of the currency (like maintaining a one-to-one to the USD dollar), then it becomes incredibly volatile.

The Lead-Up to the Terra Luna Crash

From the previous paragraph, you’ve probably figured out what might have instigated the crash in the first place.

Truth to be told, it was a gradual build-up of TerraUSD’s value, then a freak combination of factors that led to its spectacular crash.

You see, algorithmic stablecoins are fairly new in the cryptocurrency field, wherein there have been a number of unsuccessful predecessors before Terra and Luna came online.

Terra Luna was seen as the darling of decentralised finance (DeFi), because it has been able to maintain the one-to-one USD dollar peg for the most part ever since it was introduced in April 2018.

The founding company of Terra Luna and TerraUSD, Terraform Labs, was the first firm to buy a total of $10 billion in Bitcoin plus $200 million in Avalanche tokens as an extra safety net of reserves.

This move ensured that Luna had enough capital and reserves to absorb any volatility from Terra.

Just last month, Do Kwon, the main backer of Terra, had his consortium called Luna Foundation Guard buy more than US$1.5 billion in Bitcoin to shore up TerraUSD’s peg.

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Much like the stock market, the value of a cryptocurrency is dependent on how much its traders perceive it is worth. In short, it’s unavoidable to have some speculation involved in the investment.

Besides storing/banking money by exchanging it into digital assets for extra security, a trader can profit off stablecoins by lending and borrowing the cryptocurrency.

In order to encourage more people to trade with TerraUSD, DeFi lender Anchor Protocol even offered market-beating rates of 20% to traders who were willing to deposit TerraUSD on its platform.

Like any rich person will tell you, always put your money in the offshore bank account with higher interest rates for savings. Hence, you can imagine the majority of TerraUSD circulating in the market ended up being housed in the Anchor Protocol.

Then shit hit the fan.

How Did Terra Luna Crash?

First of, it’s not possible to pin the crypto crash on one specific factor.

However, in the discussions happening in the cryptoverse, many are suspecting that the attack was targeted and premeditated, for good reasons too.

Over the weekend, there was a sudden, massive surge of TerraUSD on the market, and the huge dump of the cryptocurrency caused the price of the token to fall under 99 cents.

Naturally, the arbitrage mechanism has to resolve it, right?

Regardless of how Luna was programmed, having to deal with hundreds of millions of TerraUSD suddenly dropped into the market, in a span of few seconds, isn’t something that it can handle instantaneously.

Simultaneously, $2 billion in withdrawal was made from Anchor Protocol, which was essentially functioning as a bank for $18 billion TerraUSD that was currently in circulation.

The arbitrage mechanisms couldn’t keep up.

On Monday, TerraUSD fell below 60 US cents, reaching a record-low of 20 US cents when it crashed again on Wednesday.

In a few days, the market value of TerraUSD went from US$18.4 billion to US$5 billion.

Luna nearly lost all its value: it was trading at 63 US cents on Thursday (12 May), a sharp contrast to the US$119.18 last month.

“It was a death spiral,” Lisa Wade described the situation, from her perspective as the CEO of the blockchain company DigitalX.

When $1 billion worth of TerraUSD stablecoins first flooded the market on a quiet Saturday (7 May), people panicked and it triggered the consequent selling in a low-volume market which broke the US dollar peg that Terra Luna was established on.

The selling then feeds on itself from the mechanics of algorithm, where it starts selling Bitcoin and Avalanche, which sets off more selling.

Thus, every time someone sells a Terra, they mint a Luna, which increases the amount of Luna.

But because there is no demand for Luna, the price for Luna starts going down, which causes more panic as traders start selling their Luna tokens, and this causes a negative impact for Terra as well.

To add insult to injury, the failure of Terra Luna caused the cryptocurrency traders to panic at large.

Remember how Luna had $10 billion of Bitcoin in reserves?

Shortly after its crash, Bitcoin’s value fell by 8% to $26,570, when it was worth US$40,000 just a week ago. Last November, it was valued at nearly US$70,000.

Avalanche, another token which underpins key decentralised finance protocols like TerraUSD, has also lived up to its name ironically as it declined rapidly.

Ethereum, the second largest coin by value, lost 20% of its value in the last 24 hours as well.

Preliminary reports show that the combined market value of all cryptocurrencies is now at $1.2 trillion, a mere third of its November value, with more than 35% of its losses incurred in this week alone.

Before Terraform Labs could begin to use Bitcoin to salvage the situation and re-peg TerraUSD, its reserves were worth far less than their initial estimates.

Presently, Terra Luna has no Bitcoins left in its wallet, though they have managed to get its trading prices…to minimal effect.

The Far-Reaching Consequences

The crash of Terra Luna will make traders doubt the feasibility of algorithmic stablecoins all over again.

Terra was the second largest DeFi ecosystem before its collapse.

The collapse of TerraUSD breaks the confidence traders used to have in all liquidity protocols.

If Terra can fall, then maybe Aave can too. It’s like when an investment bank fails, there will be knock-off effects where other banks will also share the portion of the doubt.

There is widespread fear in the cryptocurrency field.

Those who have weathered storms with Bitcoin are preaching the need for patience, since cryptocurrency is a relatively new field of study and investment.

But academics are already comparing it to the 2008 Financial Crisis.

They see the hallmarks of shadow banking, like circular market mechanics and extremely high leverages that have been exposed in the fallout of Terra’s ecosystem.

There is fear that it could create a second digital wave of failed lenders and wiped-out savings.

Terra Struggling to Recoup

Despite the tremendous losses, Da Kwon is determined to stick it out.

On Tuesday, he tweeted out to his followers: “Close to announcing a recovery plan for UST. Hang tight.”

Currently, the backers of TerraUSD are reportedly struggling to gain investor support for a rescue by raising US$1.5 billion to re-fortify the token after it crashed from its US dollar peg.

He hopes to provide more collateral to UST, hoping to rebuild TerraUSD’s liquidity even though it has virtually disappeared overnight.

Losing 99% of a token’s value is no joke at all, and it might be one of the most catastrophic cases seen in the cryptoverse yet.

Discussions have stalled after big-name firms were approached by various individuals with connections to Terraform Labs.

Investors think it’s unlikely that Terra will be able to regain its footing again.