The crypto world was taken by storm following the rapid collapse of the TerraUSD stablecoin. For years, investors assumed stablecoins were nearly impervious to collapse, which is why they earned the name "stablecoin." However, that's exactly with one of the world's top cryptocurrencies, which has fallen more than 99%.
Experts are already calling this the biggest crypto crash in history, with Terra's demise being compared to the collapse of Lehman Brothers in 2008. Not only could this bring about the death of the Terra blockchain, but it's led to the sudden loss of hundreds of billions of dollars for investors.
Here's what happened to Terra, who was behind this crash, and what the future holds for this now controversial cryptocurrency project.
What Is Terra Blockchain?
Terra is a crypto project that supports a number of decentralised applications (dapps), similar to Ethereum. While there are a few other use cases, the network's most popular project is TerraUSD (UST), a decentralised stablecoin, as well as its closely connected sister cryptocurrency, Luna.
Terra was founded in 2018 by economist Daniel Shin and computer scientist Do Kwon. The duo eventually founded Terraform Labs, a South Korean blockchain company that is now based out of Singapore.
What is TerraUSD?
TerraUSD is an algorithmic stablecoin pegged to the U.S. dollar (USD). Stablecoins, such as Tether (USDT), seek to minimise cryptocurrency volatility, making them a more convenient investment vehicle as well as a convenient payment option for online platforms.
Some stablecoins derive their value from being fully backed by reserves, whether that's Bitcoin (BTC) or a fiat currency like the USD. On the other hand, algorithm stablecoins rely on code and constant market activity to keep themselves pegged to the dollar.
In Terra's case, it accomplishes this using another related token, called Luna, which acts as a volatility sink. While the value of Terra is fixed to one dollar, Luna could fluctuate as much as the market demands.
Every time a UST token is minted, US$1 worth of Luna is burned, and every time a UST token is burned, US$1 worth of Luna is created. This means that when Terra falls below US$1, traders are encouraged to burn UST to create Luna, which can immediately be sold for arbitrage profit. This change in the supply of Terra is what keeps it pegged to US$1.
While it sounds complicated, this relationship between the two tokens allows TerraUSD to stay pegged at US$1, while Luna prices are free to move.
Why Did TerraUSD Become So Popular?
Over several months in early 2022, Terra was a popular and trending crypto. This surge in demand was largely driven by another savings protocol on the Terra blockchain, called Anchor. Participants were promised as much as 20% interest rates on UST tokens staked into the protocol.
Some critics warned that such high rates were unsustainable, especially for large numbers of participants. In many ways, the frenzy of buying and staking UST is similar to many other bubbles in history, including the internet crash and the 2008 mortgage crisis.
With so many people invested in the Terra ecosystem, all chasing short-term gains, it's not surprising the conditions were in place for a bubble to pop.
Why Did UST Plummet In Value?
Like most financial crashes, the crash of Terra was due to a major selloff from crypto investors. Terra owners were constantly trying to convert their Terra for cash, and the algorithm couldn't keep up.
That's what initially happened when one investor sold more than 85 million UST tokens. This massive trade put pressure on the UST peg. Further selling activity followed, and as momentum built, investors watched as Terra slowly slid below the US$1 mark it should normally trade around.
Crypto Market Was Already Falling
To make things worse, the crypto market was already declining in the days before. Risk-averse investors were pulling back their crypto exposure, largely due to the Federal Reserve raising its interest rates. This general bearishness in the market also played a role in accelerating the Terra crash, helping create the "perfect storm" of conditions that enabled this crash.
"The way these algorithmic stablecoins are designed, they have this upward force during bull markets, which is how they get so popular. But the same forces act in reverse during bear markets and expose their fundamental flaws," said blockchain engineer Sam MacPherson regarding the Terra crash.
Investors Sold Their UST For Other Stablecoins
As Terra continued to fall, stablecoin investors started to sell their UST in favour of other stablecoins that were holding their peg. At the same time, with TerraUSD falling in price, more Luna was printed in order to try and prop up the struggling stablecoin. This surge in Luna tokens led to a drastic decrease in value.
The end result is a death spiral situation, where investors kept abandoning Terra, which caused more Luna tokens to be printed, further devaluing the sister cryptocurrency that people also abandoned. It became a negative feedback loop, which ultimately resulted in the demise of both tokens. Crypto exchanges like Coinbase and Binance halted trading on both tokens shortly after.
What Can Traders Learn from UST?
Critics and reporters have called the collapse of Terra the biggest crypto crash in history. Prices for both tokens are down more than 99%, and many crypto investors lost millions of dollars overnight.
This crash affected the rest of the crypto markets as well. Terra founder Do Kwon, as well as the Luna Foundation Guard, deployed more than US$3 billion in Bitcoin to defend the peg. In doing so, there was even more downward pressure on the market, causing other investors to sell off their Bitcoin.
This entire situation highlights a few flaws in the current crypto ecosystem. Despite the hundreds of tokens out there, the entire crypto market is still closely connected. This interdependence makes it easy for the entire market to crash if just one popular crypto nose dives.
The situation also highlights the danger of crypto lending, especially for high-interest rates. A lot of the high-interest rates you see from decentralised finance (DeFi) protocols are based on the assumption that crypto growth will continue. It's the same logic that precipitated every bubble in financial history.
What's Next For UST?
Terra likely will never fully recover from this disaster. Luna used to have a market capitalisation of around US$35 billion in early 2022. Following the de-pegging of Terra, Luna's market cap is down to less than US$800 million. After hitting an all-time high of US$116, the token began to trade for US$0.0001.
As of late May 2022, the latest news is that the Terra community will instead fork into another old Terra chain known as Terra Classic. The main difference is that this retroactive Terra version will not include an algorithmic stablecoin.
This proposal, spearheaded by Terra founder Do Kwon, would also involve the creation of billions of Luna tokens, which would be distributed among current holders. Although Kwon has become a controversial figure, largely blamed for overlooking the structural flaws in the UST stablecoin, this new Terra proposal will likely pass amongst the community.
Despite this, the outlook looks grim for Terra's future. Never have we seen a top 10 cryptocurrency lose over 99% of its value in just a matter of days.This entire situation could also embolden U.S. government regulators, who have expressed a desire to crackdown on stablecoins.
"This is among the most painful weeks in crypto history and one we'll reckon with for a long time to come," said Jake Chervinsky, head of policy at the DC-based Blockchain Association.
Even if Terra does return to some degree of prominence, it's unlikely to shake the trauma of this historic crash. If anything, crypto investors are now even more paranoid about stablecoins in general.
Note: Past performance is not indicative of future results.
FXCM Research Team
FXCM Research Team consists of a number of FXCM's Market and Product Specialists.
Articles published by FXCM Research Team generally have numerous contributors and aim to provide general Educational and Informative content on Market News and Products.
Retrieved 18 May 2022 https://decrypt.co/100402/how-terra-ust-luna-imploded-crypto-crash
Retrieved 19 May 2022 https://time.com/6177567/terra-ust-crash-crypto/
Retrieved 20 May 2022 https://www.yahoo.com/video/kwon-proposes-terra-fork-ditch-011954163.html
Retrieved 21 May 2022 https://coinmarketcap.com/currencies/terra-luna/