One of the biggest catastrophes in the world of cryptocurrencies happened with the collapse of LUNA, the native currency of the Terra blockchain. The LUNA token went from a price of $100 to a fraction of a cent in days. The blockchain debacle happened due to the loss of parity of the dollar with its stablecoin UST, which caused the massive sale of UST and LUNA.
One of the most promising blockchain projects in the entire cryptocurrency market collapsed and generated losses of more than 45 billion dollars.
The Terra blockchain was a project founded in 2018 by Daniel Shin and Do Kwon to innovate decentralized stablecoins. The blockchain was built through the different development systems of the Cosmos project. It allowed the blockchain to process thousands of transactions per second, which generated interest from several investors.
LUNA, the native currency of this blockchain, was intended to perform staking, pay transaction fees and vote on governance proposals.
How does Terra (LUNA) Work?
The LUNA token also had a fourth use by holding the parity of decentralized state currencies issued by the blockchain. Under an innovative mechanism for minting and burning tokens, the blockchain managed several decentralized stable currencies at parity with real currencies such as the dollar, the Korean won, the euro, and the Chinese yuan, among others.
The largest decentralized currency on Terra was UST, which worked under the mechanism of burning and minting tokens. All decentralized stablecoins on the blockchain worked under the same agency as UST. 1 LUNA could be burned to mint 1 UST on the Terra blockchain and vice versa.
Suppose UST is priced at $1.20; in this case, the arbitrageurs could burn 1 LUNA to mint 1.20 UST and sell this UST. In this way, the arbitrageurs would have a profit of 20%, and also the supply of UST would increase. The combination of UST selling pressure and the increased supply of the token would cause UST to return to its dollar peg.
This process also applies in the other direction. If 1 UST is priced at $0.50, arbitrageurs could burn 1 UST to mint the equivalent in LUNA at a 100% profit, assuming they sold LUNA for another token. In the same way, a reduction in UST supply and the token buying pressure would cause UST parity with the dollar.
Terra announces LUNA Foundation Guard (LFG) to preserve Terra´s ecosystem
The exponential risks that UST could cause in all blockchains and the dozens of DeFi protocols forced the developers of Terra to found LFG. His goal was to preserve the Terra ecosystem, focusing on maintaining UST’s peg to the dollar.
One of the proposals to support this parity was to buy BTC as a UST reserve; LFG will lend $750 million worth of Bitcoin 750 million UST to market makers in order to help stabilize UST. In this way, if the UST parity were to be lost, LFG could sell BTC to buy UST and maintain its parity.
Even though BTC was the main asset of LFG, as a reserve for the protection of UST, the organization began to accumulate several cryptocurrencies: BTC, AVAX, BNB, USDT, USDC, UST, and LUNA. Do Kwon then announce that he would gather a reserve of all cryptocurrencies in which UST was available? With all these assets backing UST, its peg to the dollar would theoretically remain stable.
Despite all the precautions that the Terra developers took, on May 7, 2022, UST lost its parity with the dollar. It caused a cycle of selling UST and LUNA, which ended in the collapse of both tokens a few days later.
Why did LUNA fall?
The Terra community approved various governance proposals to establish UST as the primary decentralized stablecoin on multiple blockchains such as Avalanche, Harmony, Solana, Ethereum, Matic, and BSC. Blockchains offered incentives in UST, LUNA, and other tokens for users to use UST as their primary stablecoin.
The primary demand for UST was due to Anchor Protocol, a DeFi platform that offered users 20% annual returns in UST. It caused a massive demand for UST, and under the mint and burn mechanisms, large amounts of LUNA were burned to mint UST.
Consequently, LUNA’s supply fell drastically, and its price increased significantly. Its highest price was recorded on April 3 at $116, making it the sixth-largest cryptocurrency by market capitalization, while UST became the third-largest stablecoin in the crypto market.
How did the LUNA and UST Tokens Crash?
On Saturday, May 7, the Terra team withdrew a large amount of UST from Curve Finance, a decentralized exchange for stablecoins. At the same time, a «whale» sold 85 million UST for 85 USDC, pushing the UST slightly below par.
These events created selling pressure for UST. Since the crypto market was in a downward trend, institutions and investors saw a risk of UST losing parity with the dollar and started selling the token. Similarly, they made several centralized and decentralized platforms exposed to UST; they sold their tokens out of fear that their parity would continue to decline.
65% of UST was removed from the Anchor Protocol platform in the first 48 hours of UST losing parity.
It produced even more selling pressure and drove the UST significantly below par. From this, the arbitrageurs began to burn UST, generating LUNAs and selling them immediately.
The above caused the price of LUNA to drop due to the increased supply of the coin. In addition to this, the downward trend of the cryptocurrency market made wholesale and retail investors lose confidence in LUNA and UST. There was then massive selling pressure on the two primary tokens of the Terra blockchain.
With all these variables, the price of LUNA collapsed from $100 to fractions of a cent in less than a week.
Terra ends token burning and wedge mechanism
The Terra blockchain and its validators decided to stop the blockchain and remove the mechanism of burning and minting tokens to stop the fall of the entire ecosystem. On the other hand, LFG sold most of the BTC in reserve to maintain the UST peg. It can be confirmed by looking at LFG’s digital wallet address, which was revealed early on.
When writing this article, the wallet only had 313 BTC of the 80 thousand 394 that LFG had as a reserve, as confirmed by LFG on Twitter. Despite efforts to keep the UST pegged to the dollar by selling BTC, the Terra ecosystem collapsed on May 13, 2022, with the loss of over $45 billion from the cryptocurrency market.
Although there is much speculation about the Terra debacle, it is clear that the mechanisms underlying algorithmic stablecoins need to be more robust. The Terra blockchain was a very successful experiment. Prominent VCs, institutions, and retail investors backed it, so various developers and regulators will remember it as a traditional and decentralized economic system.
Starting from the crisis of the Terra ecosystem, Do Kwon announced the creation of a new blockchain known as Terra 2.0. In this new blockchain, investors who had both Luna and UST will be rewarded with an airdrop of the new blockchain token, Luna 2.0. If you are one of the LUNA investors, you can check the amount of Luna 2.0 given to you as an airdrop in this article.
This new blockchain has Luna 2.0 as its native currency, but there is no mechanism to create a stable currency like the previous blockchain. The Terra blockchain continues to function as Terra Classic, and its coins now have the names LUNC and USTC.
The Mirage of the Lunatics
There is no denying that this event damaged the reputation of the cryptocurrency industry and its new financial system. UST was a direct threat against the US dollar as it functioned as an algorithmic stablecoin backed by Bitcoin, known as digital gold.
UST was everything the economic system behind the US dollar wanted to avoid altogether. This catastrophic event was especially beneficial for the US currency and helped it in its goal to remain the most powerful currency on the planet.
The Luna debacle leaves behind a very ambitious project of those who called themselves «lunatics,» whose mirage caused significant damage to the entire cryptocurrency ecosystem. The recovery of this market will be seen if Bitcoin can resume its upward trend in the remainder of the year; otherwise, the market will continue to fall.