At one point, the Terra Luna blockchain was valued at $40 billion. Then, it came crashing down. Now, each Luna coin is worth $0. Let’s talk about how this happened and what’s next for the whole crypto world after the epic Terra Luna crash?
In 2018, South Korean Do Kwon, 30, founded Terraform Labs, shortly after earlier digital currency project Basis failed. In effect, Kwon’s Terraform Labs created two sister digital currencies – the TerraUSD (UST) and Luna. Each serves different purposes. UST was always meant to be a stablecoin, so its value remains consistently at just $1. Unlike traditional stablecoins, however, UST is much more ‘algorithmic’. Meaning, it is not backed by any physical asset or holdings in banks to protect its value.
Enter Luna – UST’s sister-slash-partner currency – which is meant to balance the two and keep UST’s dollar peg. While UST’s value is consistently just – more or less – a dollar, Luna, like other cryptocurrencies, rises and falls.
How do the two balance each other, and how does UST keep its dollar peg minus the physical reserves? Well, Terra’s system goes like this: minting a UST is equivalent to burning a dollar-worth of Luna, and vice-versa. Theoretically, this relationship balances out the supply-demand of the coins, and therefore, stabilises the price. The ‘algorithmic’ dollar protects the coin value and investor assets.
In essence, what shouldn’t happen to ensure the ‘balance’ and integrity of the algorithm and the Terra ecosystem is UST value dropping below a dollar and continuing to plummet — which is where it’s at now.
So, how did Terra Luna crash exactly?
Leading to the Terra Luna crash
The UST enjoyed an all-time high of $1.09 for over a year since 2021 before it nosedived to $0.04 in May 2022. Its sister coin, Luna was valued at an all-time high of $119 and then historically plunged to $0. It spelt panic and investors were scrambling to liquidate.
On May 16, the Terra blockchain halted its operations after an overnight 100% drop in the token’s price. How did this happen?
For one, the broad crypto market has been bleeding recently. Bitcoin plunged in the first two weeks of May – so did the rest. And this pushed the value of Luna downward. As a result, UST, relying on Luna to absorb price volatility shocks, went below a dollar. The market hasn’t fully recovered yet; for the Terra ecosystem, things look bleak as does investor confidence.
Another major reason for the crash – Anchor protocol, a borrowing/lending platform on the chain. The Terra network promised a 20% annual percentage yield to investors who bought UST and loaned it back to Anchor. Investors scrambled when they heard the news. At one point, 75 per cent of UST coins are parked in Anchor. So, one thing’s clear: investors are after the 20 per cent APY and Terra is using the protocol to attract capital. But when news of Luna losing value and UST depegging, investors ran for the exit, leaving the protocol dry.
The promise of an algorithmic stablecoin with no fiat or collateral guarantees to hedge against the volatility of cryptocurrency and protect investors … well, it was broken. The architecture of the crypto subsector is, at the very beginning, already very risky. In 2021, Dr Ryan Clements of the University of Calgary Faculty of Law published his study ‘Built to Fail: The Inherent Fragility of Algorithmic Stablecoins’.
According to Clements, such coins ‘are not stable at all but exist in a state of perpetual vulnerability’; he went as far as to say algorithmic stablecoins are ‘fundamentally flawed’. The Terra ecosystem is believed to be unsustainable from the very beginning because it heavily relies on market sentiment and demand volume, with no guarantee from collaterals or fiat reserves whatsoever.
Call for regulations?
Kwon, who is very visible and active on Twitter, has just recently announced he is ready to leave the project behind and move forward to another one: Terra 2.0 chain. #TerraisMoreThanUST, he tweets and has rallied the support of Terra builders to realise his proposal to create a hard fork back to the classic Luna. Following the Terra fiasco, however, investors aren’t excited about the rebuild.
Terra investors are hurt; sceptical regulators are watching. In recent weeks, the crypto market was in a freefall, and investors are losing their money – life savings – due to the epic Terra Luna crash and how it took down with it the sector.
Dr. Clements, in his study mentioned above, wrote there is a need for regulatory guidelines on stablecoins, such as transparency safeguards, risk disclosure and containment measures.
In the wake of the Terra Luna catastrophe, authorities are taking an even closer look at the crypto space. French central bank head Francois Villeroy de Galhau told Reuters that crypto assets will be discussed during a G7 meeting this May.
What happened in the recent past is a wake-up call for the urgent need for global regulation’, said Galhau.
In March 2022, the European Union adopted the Markets in Crypt-assets (MiCA) Regulations. As an overview, MiCA was created to protect investors, ensure the crypto market integrity and prevent market manipulation as well as potential economic crimes like money laundering and terrorist financing.
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