The cryptocurrency market isn’t pretty right now. Red is everywhere: bitcoin and ether are at their lowest points since 2020, and altcoins like dogecoin and cardano are faring even worse. While it’s painful for crypto investors, this dip is far from unprecedented. Cryptocurrencies are infamous for their volatility, and tempestuous economic conditions are bringing down not just crypto, but the stock market too.
What is unprecedented, however, is the collapse of the luna cryptocurrency and tis associated TerraUSD (UST) stablecoin. You may not have heard of UST before, or know what ais, but it’s a big deal. Billions of dollars in crypto wealth has been vaporized, sending shockwaves throughout the whole market.
There are two intertwined stories here: That of the UST stablecoin and that of luna, both of which are part of the Terra blockchain. The UST coin is designed to retain a value of one US dollar at all times, but depegged last Monday, on May 9, and has since fallen to just 17 cents. Then there’s luna, the centerpiece of Terra’s ecosystem. Its value has collapsed in one of the most stunning crypto crashes ever recorded.
The coin’s price fell from $116 in April to just a penny on Thursday. Its fallen further, trading over the weekend for a fraction of a cent. At the time of writing, luna is down to an eighth of a penny. Such an implosion has been seen for small-cap memecoins in the past, but never for something the size of luna, which had a market cap of over $40 billion just last month.
“This is historic for the crypto markets,” said Mike Boroughs, cofounder of crypto investments firm Fortis Digital. “This is a defining moment for the space due to its size and impact in terms of the amount of people that lost substantial value.”
Here’s what you need to know.
What’s a stablecoin?
To understand the crypto catastrophe, you first need to know what a stablecoin is. In essence, it’s a cryptocurrency that’s pegged to a more stable currency. The biggest such coins are Tether and USDC, which like most stablecoins are both tied to the US dollar. So if you have 1,000 USDC tokens, for instance, they can at any time be exchanged for 1,000 US dollars.
Stablecoins are integral parts of “DeFi” (decentralized finance), designed to be ways for investors to hedge against the volatility of the cryptocurrency market. Say ether’s price is $2,000, a trader could exchange one ether for 2,000 USDC tokens. If tomorrow ether drops 50% to $1,000, those 2,000 USDC tokens would still be worth $2,000 and could be traded for two ether tokens. When investors smell a downswing coming, they put their money on stablecoins like Tether, USDC and, until this week, UST.
Stablecoins also provide the means for cryptocurrency loaning and borrowing, making them a foundational technology of DeFi.
The Terra UST coin is different to Tether and USDC in a key way. Tether and USDC are backed by actual US dollars, whereas UST is what’s known as an “algorithmic” or “decentralized” stablecoin. The idea is that, through a few clever mechanisms, plus billions in bitcoin reserves, the UST’s dollar peg can be maintained without it having to be backed by actual US dollars.
“A decentralized stablecoin is the Holy Grail of DeFi,” explained Cyrus Younessi, former Head of Risk Management at MakerDAO, the group behind DAI stablecoin. Bitcoin and ether’s selling point is that they’re difficult for bureaucrats, politicians and central bankers to control, but their downside is price volatility. “If you could take those assets, extract stability out of them and productize it, then that’s huge,” Younessi said.
“But it’s not very viable.”
Terra, luna and UST: What are they?
Terra is a blockchain, just like ethereum and bitcoin. While ethereum’s blockchain natively produces ether tokens, Terra natively produces luna. Before the depeg, luna was trading at $85.
To create UST, you need to burn luna. So for instance, last week you could trade one luna token for 85 UST (since luna was worth $85), but the luna would be destroyed (“burned”) in the process. This deflationary protocol was meant to ensure luna’s long-term growth. As more people buy into UST, more luna would be burned, making the remaining luna supply more valuable.
To entice traders to burn luna to create UST, creators offered an insane 19.5% yield on staking — which is essentially crypto terminology for earning 19.5% interest on a loan — through what they called the Anchor Protocol. Instead of parking your savings at a bank for a 0.06% interest rate, the pitch is to turn put your money into UST, where it can earn nearly 20% in interest. Before the depegging, over 70% of UST’s circulating supply, around $14 billion, was deposited in this scheme.
Here’s the key to UST retaining its peg: 1 UST can always be exchanged for $1 worth of luna. So if UST slips to 99 cents, traders could profit by buying a huge amount of UST and exchanging it for luna, profiting one cent per token. The effect works in two ways: People buying UST drives the price up, and UST being burned during its exchange to luna deflates the supply.
Then there’s the reserves. Terra founder Do Kwon created the Luna Foundation Guard (LFG), a consortium whose job it is to protect the peg. The LFG had about $2.3 billion in bitcoin reserves, with plans to expand that to $10 billion-worth of bitcoin and other crypto assets. If UST dipped below $1, bitcoin reserves would be sold and UST bought with the proceeds. If UST goes above $1, creators would sell UST until it goes back to $1, with the profit being used to buy more bitcoin to pad out the reserves.
It all makes sense. But UST is, at the time of writing, is worth 17 cents.
What went wrong?
It all started on Saturday, May 7. Over $2 billion worth of UST was unstaked (taken out of the Anchor Protocol), and hundreds of millions of that was immediately sold. Whether this was a reaction to a particularly volatile period — interest rates going up has particularly effected cryptocurrency prices — or a more malicious attack on Terra’s system is an ongoing topic of debate.
Such huge sells pushed the price down to 91 cents. Traders tried to take advantage of arbitrage, exchanging 90 cents worth of UST for $1 worth of luna, but then a speed bump appeared. Only $100 million worth of UST can be burned for luna per day.
Investors, already flighty in the current gloomy market, flocked to sell their UST once the stablecoin couldn’t retain its peg. It bounced between 30 and 50 cents in the week following the initial depeg, but has now fallen to a steady low of under 20 cents. Its marketcap, which was around $18 billion in early May, now stands at $2 billion.
It’s worse for luna holders. The value of luna tokens has almost completely disappeared: After reaching a high of just under $120 in April, luna’s current price is a fraction of a penny.
On the possibility of this being a malicious attack. Some have speculated that an attacker attempted to break UST in order to profit from shorting bitcoin — that is, betting on its price going down. If would-be attackers created a large position in UST and then unstaked $2 billion at once, it could depeg UST, which would mean Terra’s team would have to sell portions of its bitcoin reserve to repeg the stablecoin. Once investors saw that UST lost its peg, they would then rush to unstake and sell their UST, which would require more bitcoin reserves to be sold, adding further sell pressure.
Again, this is still speculation. Younessi is unsure whether the depeg was caused by a coordinated attack or not, but said that the responsibility is on crypto developers to create more secure systems.
“Our job as DeFi builders is to build systems that are resistant [to exploits],” he said. “That’s literally in the original threat model that anyone in crypto builds: How would this hold up if a guy with $100 billion came in and tried to take this down?”
Four years ago, while working as a DeFi analyst at Scalar Capital, Younessi called Terra’s model “broken”.
“Terra could have grown to be 10 times as large” before such a crash, he said to CNET. “Better that we prick that bubble of unsustainable protocols sooner than later.”
Why does it matter?
This matters for three reasons.
First, over $15 billion in crypto value has been wiped out through luna and UST alone. There have been anecdotal reports of self-harm by those who had most of their savings staked in UST — though these can’t be confirmed, it’s clear that a lot of people lost a lot of money in the collapse. The damage isn’t contained to Terra’s ecosystem though, as Fortis Digital’s Boroughs notes. Many who were exposed to luna and UST would have sold off big parts of their crypto portfolio to recoup some of the damage, pulling the entire market down.
Second, it raises questions about other stablecoins. Again, UST was unusual in that it was an algorithmic stablecoin, unlike tether and USDC. But the stability of those coins has always been somewhat in doubt: For instance New York’s attorney general last year accused tether of lying about how much it actually held in dollar reserves.
Boroughs worries that, if UST was attacked, similar plays could be made against the others.
“The question in our minds becomes, does what happened to UST spread to other stablecoins?” he said. “If big whales found a playbook here that works to attack UST, we worry they may reuse that playbook in other areas of the market.”
Lastly and possibly most signifcantly, the collapse of UST has caught the attention of powerful politicians and regulators. Secretary of the Treasury Janet Yellen said on Tuesday that UST’s depegging “simply illustrates that this [stablecoins] is a rapidly growing product and there are rapidly growing risks.”
“One place we might see some [regulatory] movement is around stablecoins,” SEC Commissioner Hester Pierce said Thursday
What’s next for Luna and UST?
It’s been a rough week for Terra developers since UST depegged on May 10. Prominent figures have asked pertinent questions about Terra’s bitcoin reserves, and the Terra blockchain has stopped operating on two occassions. Meanwhile, Do Kwon, CEO of Terralabs, says he has a plan to restore Luna’s value and re-peg UST.
As noted above, the Luna Foundation Guard had around $2.3 billion worth of bitcoin. In the event of a depegging, those reserves were to be sold, with the resulting liquidity used to buy UST back up to $1. So why didn’t it work?
Some have questioned how the LFG actually used the money. Over the course of a day, on May 9, around $1.6 billion worth of bitcoin was sent from LFG’s wallet to Gemini, a crypto exchange. Another $875 million was sent to a wallet on Binance, the world’s biggest crypto exchange. What happened from there can’t be traced on either Gemini or Binance.
That lack of transparency has many confused — including Changpeng Zhao, the founder and CEO of Binance. “Where is all the BTC that was supposed to be used as reserves?” he tweeted Saturday. “Shouldn’t those BTC be ALL used to buy back UST first?”
“We are currently working on documenting the use of the LFG BTC reserves during the depegging event,” Terralabs CEO Do Kwon tweeted on Saturday. “Please be patient with us as our teams are juggling multiple tasks at the same time.”
“I am heartbroken about the pain my invention has brought on all of you,” Kwon said in a tweet.
Kwon’s statement came a day after Terra’s blockchain was halted, meaning transactions of any kind were no longer possible, while a plan to “reconstitute” the ecosystem was being created.
Do Kwon on Friday proposed a solution to Luna’s ills. The Terralabs CEO suggested forking Terra — meaning, creating a new blockchain. A snapshot of current Luna and UST holders would be taken, and 900 million Luna tokens would be distributed among this group, with a remaining 100 million going to a “community pool to fund future developments.” In essence, it’s an attempt to reset the blockchain to its state before the depegging.
Many, including Zhao, are skeptical that the plan will work.