Luna Crypto Crash, the cryptocurrency market is now in disarray. Bitcoin and ether are at their lowest levels since 2020, while altcoins such as dogecoin and Cardano are faring considerably worse. While it is upsetting for crypto investors, this drop is not uncommon. Cryptocurrencies are notorious for their volatility, and volatile economic conditions are pulling down not just crypto but also the stock market.

The collapse of the luna cryptocurrency and its accompanying terraUSD stablecoin, dubbed UST, is unprecedented. You may not have heard of UST or a stablecoin before, but it’s a significant thing. Billions of dollars in cryptocurrency riches have vanished, sending shockwaves across the whole market.

There are two connected tales here: the UST stablecoin’s and luna’s, both of which are part of the terra blockchain. The UST coin is meant to always have a value of $1, but it was depegged last Monday, May 9, and has since dropped to barely 17 cents. Then there’s Luna, the ecosystem’s focal point. Its value has plummeted in one of the most spectacular crypto collapses ever witnessed.

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The coin’s value dropped from $116 in April to a penny on Thursday. It has dropped, even more, trading for a fraction of a penny over the weekend. Luna is now worth an eighth of a cent at the time of writing. Such a crash has already occurred for small-cap memecoins, but never for anything the magnitude of luna, which had a market valuation of more than $40 billion just last month.

“This is historic for the crypto markets,” said Mike Boroughs, co-founder of crypto investments firm Fortis Digital. “This is a defining moment for the space due to its size and impact in terms of the number of people that lost substantial value.”

What’s a stablecoin?

To grasp the crypto disaster, you must first understand what a stablecoin is. It is, in essence, a cryptocurrency that is linked to a more stable currency. The most popular of these currencies are tether and USDC, which, like other stablecoins, are tethered to the US dollar. So, if you have 1,000 USDC tokens, you may trade them for $1,000 at any moment.

Stablecoins are essential components of “DeFi,” or decentralized finance, and are intended to help investors hedge against the volatility of the cryptocurrency market. Assume the price of ether is $2,000; a trader might swap one ether for 2,000 USDC tokens. If ether falls 50% to $1,000 tomorrow, the 2,000 USDC tokens are still worth $2,000 and can be exchanged for two ether tokens. When investors anticipate a downturn, they place their bets on stablecoins like as tether, USDC, and, until this week, UST.

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Stablecoins also allow for bitcoin lending and borrowing, making them a key DeFi technology.

The terra/UST coin differs from tether and USDC in one important way: it is not backed by actual US dollars, but rather is an algorithmic or decentralized stablecoin. The concept is that the UST’s dollar peg can be maintained without needing to be backed by the dollar via a few smart techniques and billions in bitcoin reserves.

“The Holy Grail of DeFi is a decentralized stablecoin,” said Cyrus Younessi, former head of risk management at MakerDAO, the firm behind the DAI stablecoin. The benefit of bitcoin and ether is that they are difficult to regulate for bureaucrats, politicians, and central bankers, but the disadvantage is price volatility. “If you could extract stability from those assets and productize it, that would be significant,” Younessi added.

“But it’s not very viable.” 

What are Terra, Luna, and UST?

Terra, like Ethereum and bitcoin, is a blockchain. While the Ethereum network creates ether tokens naturally, Terra’s blockchain produces luna tokens natively. Prior to the depreciation, luna was trading at $85.

You must burn luna to make UST. For example, last week you could exchange one luna token for 85 UST (since the luna was valued at $85), but the luna would be destroyed (“burned”) in the process. This deflationary technique was designed to safeguard the long-term growth of the luna. As more individuals invest in UST, more luna will be burnt, increasing the value of the remaining luna supply.

To attract traders to burn luna to generate UST, the Anchor Protocol provided a ridiculous 19.5 percent yield on staking – which is effectively crypto slang for earning 19.5 percent interest on a loan. Instead of putting your money in a bank for a 0.06 percent interest rate, the pitch is to put it in UST, where it may yield over 20 percent. Prior to the depegging, this scheme held over 70% of UST’s circulating supply, or over $14 billion.

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The key to UST holding its peg is as follows: One UST may always be traded for one luna. So, if UST falls to 99 cents, traders might benefit by purchasing a large quantity of UST and trading it for luna, earning one cent for each token. The impact operates in two ways: people buying UST raises the price, and UST consumed during its conversion to luna deflates the supply.

The reserves come next. Do Kwon, the creator of Terra, established the Luna Foundation Guard, a consortium tasked with protecting the peg. The LFG had around $2.3 billion in bitcoin reserves, with intentions to increase this to $10 billion in bitcoin and other digital assets. If UST fell below $1, bitcoin reserves would be liquidated and the money used to purchase UST. If UST rises over $1, creators will sell UST until it returns to $1, with the proceeds used to purchase additional bitcoin to replenish reserves.

Everything makes sense. However, at the time of writing, UST was worth 17 cents.

The Luna Crypto Crash What happened?

It all began on Saturday, May 7. Over $2 billion of UST was unstacked (taken out of the Anchor Protocol), with hundreds of millions of dollars sold instantly. It’s unclear if this was a reaction to a particularly tumultuous moment (the rise in interest rates has had a particular impact on cryptocurrency values) or a more deliberate attack on Terra’s infrastructure.

Such massive sales drove the price down to 91 cents. Traders attempted arbitrage by swapping 90 cents worth of UST for $1 worth of luna, but a speed bump emerged. Only $100 million of UST can be burnt every day for luna.

Investors, already jittery in the current bear market, hurried to sell their UST after the stablecoin failed to maintain its peg. It fluctuated between 30 cents and 50 cents in the week following the first depeg, but has since dropped to a consistent low of fewer than 20 cents. Its market capitalization has dropped from roughly $18 billion in early May to $2 billion currently.

It’s much worse for luna owners. The worth of luna tokens has almost totally vanished: After peaking at slightly under $120 in April, the current price of luna is a fraction of a cent.

Concerning the potential of a malicious assault. Some believe that an attacker attempted to breach UST in order to benefit from shorting bitcoin or speculating on its price falling. If potential attackers established a significant position in UST and then unstaked $2 billion all at once, it might depeg UST, requiring Terra’s staff to sell sections of its bitcoin reserve to repeg the stablecoin. When investors realized that UST had lost its peg, they would hurry to unstack and sell their UST, requiring additional bitcoin reserves to be liquidated, adding to the selling pressure.

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Again, this is just conjecture. Younessi is uncertain whether the depeg was the result of a concerted effort, but he believes it is the responsibility of crypto engineers to design better secure systems.

“As DeFi builders, our duty is to develop systems that are resistant [to exploitation,” he explained. “That’s essentially in the original threat model that everyone in crypto builds: how would this stand up if a man with $100 billion came in and attempted to bring it down?”

Younessi described Terra’s business as “broken” four years ago when working as a DeFi analyst at Scalar Capital.

“Terra may have expanded to be ten times as big” before the collision. “We should burst that bubble of unsustainable practises sooner rather than later.”

The Luna Crypto Crash: Why does it matter?

Over $15 billion in cryptocurrency worth has been lost due to luna and UST alone. Anecdotal stories of self-harm by persons who had most of their assets invested in UST have surfaced; while these cannot be corroborated, it is apparent that many people lost a lot of money in the crash. However, as Fortis Digital’s Boroughs point out, the devastation isn’t limited to Terra’s biosphere. Many people who were exposed to luna and UST would have liquidated large portions of their crypto holdings to recuperate some of the losses, dragging the market down with them.

It begs the question of alternative stablecoins. UST was unique in that it was an algorithmic stablecoin, as opposed to tether and USDC. However, the stability of those coins has long been questioned: For example, New York’s attorney general accused tether last year of misrepresenting how much it actually maintained in currency reserves.

Boroughs are concerned that if UST is targeted, similar moves will be taken 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.” 

Finally, and perhaps most importantly, the fall of UST has piqued the interest of prominent politicians and authorities. On Tuesday, Treasury Secretary Janet Yellen stated that UST’s depegging “just underscores that this [stablecoins] is a quickly increasing product with rapidly growing dangers.”

“We may see some [regulatory] activity surrounding stablecoins,” Securities and Exchange Commission member Hester Pierce said on Thursday.

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