LUNA to the Moon? A Simple Explanation of Terra’s Extraordinary Crash

How did UST crash and tank the entire crypto market?

The collapse of TerraUSD (UST) sent shockwaves through the cryptocurrency market, highlighting the vulnerabilities of algorithmic stablecoins and the broader implications for crypto investors. Understanding the events leading up to the UST crash and its aftermath is crucial for anyone involved in cryptocurrency investments.

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What do Venezuela and Terra have in common? Well, it turns out that printing money leads to massive inflation and a subsequent devaluation of the currency being printed. Who would’ve thought?

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But to understand why this is relevant to Terra, let’s take a step back and first discuss what Terra even is. Terra is a crypto project founded in early 2018 by Do Kwon (currently CEO) and Daniel Shin (left in 2020). Terra is (or was?) an ecosystem of decentralized stablecoins, with its largest being TerraUSD, or UST for short. LUNA is Terra’s native cryptocurrency coin and is separate from UST.

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What is a stablecoin?

Stablecoins are cryptocurrencies that are supposed to track the value of fiat currencies. Most stablecoins, such as Tether (or USDT for short), are pegged to the US dollar. This means that 1 USDT should, in theory, be worth 1 USD.

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But how do stablecoins retain their value? USDT is backed by fiat held as collateral, similar to how the US dollar used to be backed by the gold standard. This means that Tether holds in its reserves USD (and similar assets such as US Treasuries) equivalent in value to all outstanding USDT. So in theory, 1 USDT should always be able to be exchanged for $1, providing a floor for USDT.

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Algorithmic stablecoins: Good intentions with a bad outcome

Now that we know what a stablecoin is, what is UST (TerraUSD) and how is it different? UST is what’s known as an algorithmic stablecoin. Unlike normal stablecoins, which are backed by real reserves, algorithmic stablecoins are not backed by any sort of collateral.

So if normal stablecoins were doing so well, why experiment with algorithmic ones? Well, the main problem with fully-backed stablecoins is that there may not be enough collateral to meet demand. For a while, Terra successfully solved this problem and became the third largest stablecoin by market cap. However, as we all saw, this achievement was short-lived given fatal flaws in its underlying regulation mechanism.

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How does (or did?) UST work?

UST attempted to maintain its peg to USD through a supply regulation mechanism known as mint and burn. This is where LUNA comes in: 1 UST is worth $1 worth of LUNA. Keep this in mind as we look at two simple examples.

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1. UST is trading above USD, i.e. 1 UST is worth more than $1

Let’s say for some reason 1 UST is trading at $1.05. When this happens, an arbitrage opportunity arises: Borrow $1 to buy $1 worth of LUNA → Give $1 worth of LUNA to the Terra system and get back 1 UST → Sell 1 UST on the open market for $1.05  → Pay back the borrowed $1, resulting a 5% profit. This increases the supply of UST in the open market, thereby pushing the price down until 1 UST once again equals $1.

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What happens to the $1 worth of LUNA that was exchanged? It’s burned by the Terra system. This decreases the amount of LUNA in circulation, which increases its price. Keep this in mind for later.

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2. UST is trading below USD, i.e. 1 UST is worth less than $1

In this example, let’s say 1 UST is trading at $0.95. Another arbitrage opportunity presents itself: Borrow $0.95 to buy 1 UST → Give 1 UST to the Terra system in exchange for $1 worth of LUNA → Sell $1 worth of LUNA for $1 on the open market → Pay back the borrowed $0.95, resulting in a 5% profit. This reduces the supply of UST in the open market, thereby increasing the price of UST until 1 UST equals $1.

In this example, where did the Terra system get the $1 worth of LUNA? It was minted. This increases the amount of LUNA in circulation and decreases its price.

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So in summary, as UST goes above its peg, LUNA is bought and burned, which pushes LUNA’s price up. As UST goes below its peg, LUNA is minted and sold, pushing LUNA’s price down.

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Everything is fine and dandy so long as there is demand for UST and LUNA. People buy UST → UST maintains its peg by getting exchanged for LUNA → LUNA is burned, leading to an increase in its value → LUNA’s increase in value leads to an increase in demand for UST → And the cycle is repeated. Everyone is making money. Everyone wins.

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This all sounds great until we realize that LUNA, the anchor of the mint and burn mechanism, doesn’t have any intrinsic value. So what happens when $1 worth of LUNA is no longer worth $1? Well, the entire regulation mechanism breaks down and leads to a death spiral.

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Terra’s Death Spiral

Let’s look at a third example. Assume that 1 UST is trading at $0.95, but $1 worth of LUNA is now also trading at $0.95. Here, there is no arbitrage opportunity and, therefore, no incentive to convert UST into LUNA. UST loses its peg to USD as the regulation mechanism breaks down. This is exactly what happened to Terra.

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The Fed started increasing interest rates to fight inflation, which triggered a global sell-off of risky assets. In the stock market, this included high valuation stocks such as tech stocks. In crypto, it was virtually everything. There were some very large sales of both UST and LUNA, which some speculate was a deliberate attack while others believe was purely due to market events. In any case, the sell-offs happened and put significant downward pressure on LUNA and UST, which initiated a death spiral:

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People sell UST → UST loses its peg → LUNA is minted and exchanged for UST in order to stabilize UST’s price → LUNA’s supply increases, which decreases LUNA’s value → UST holders lose faith in LUNA and sell UST → And the spiral continues.

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We saw this death spiral play out the week of May 1st, 2022. At its high, LUNA was trading above $100. Within a matter of days, the amount of LUNA in circulation went from a few hundred thousand to 6.5 trillion, which caused its value to go to nearly $0 and UST to trade significantly below its intended $1 peg. At the time of writing, LUNA is trading at just $0.0001 and UST is trading at just $0.06. Yikes.

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Terra’s Future

Although the future of Terra is uncertain, it seems likely that the Terra blockchain will be forked. Do Kwon proposed that the new chain will be called Terra (token: LUNA) and will not have algorithmic stablecoins. The old chain will continue to exist as Terra Classic (token: LUNC).

If everything goes according to plan, the new blockchain will be live by May 27th, 2022. According to Kwon, new LUNA tokens will be airdropped to LUNC stakers, holders, residual UST holders, and essential app developers of the Terra Classic blockchain. The drops will happen in a way that compensates holders before the crash more than speculative buyers post-crash.

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Regardless of what happens, Terra’s downfall will serve as a painful but important lesson for the crypto community. I am hoping for the best outcome for all those who are affected.

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