The highlight of what could be branded the craziest week in crypto history ever was a debacle of the Terra ecosystem.
Terra blockchain, which houses the $LUNA (governance token) and the $UST (stablecoin) crashed in one of the most stunning fashion ever, dragging individuals and corporate institutions’ investments with it.
To put this more simply, $LUNA, formerly a top 10 coin by market cap which peaked at $119 on April 5, fell almost 100% to a fraction of a cent. Its sister coin – $UST, designed to stay pegged at $1, lost the peg and plummeted as low as 13 cents.
Background knowledge of how the Terra ecosystem works is necessary to understand the significance of the crash. So, let us get to it.
Here is how it works
Terra is a blockchain that natively produces $LUNA and $UST. $UST, until last week, was branded as a stablecoin.
A stablecoin is a cryptocurrency that is pegged to fiat like the US dollar, Euro and Naira. They are designed as ways for investors to hedge against the volatility of the cryptocurrency market. Predominant stablecoins in the market are USDT and USDC.
The UST which is known as an algorithmic or decentralized stablecoin is different from tether and USDC in a way – it is not backed by the US dollar. The idea behind $UST is that, through some mechanisms and billions of dollars in bitcoin reserves, the dollar peg can be maintained without being backed by the dollar.
1 UST can be exchanged for $1 worth of luna. So, when UST drops to 99 cents, traders profit by buying a huge amount of UST and exchanging it for luna, profiting 1 cent per token. The bigger the difference to the peg is, the more profitable the arbitrage would be.
The effect of this mechanism is that buying UST drives the price up. Then, the exchange of UST to Luna reduces the stablecoin’s supply.
In contrast, the LUNA is depleted to create UST, using the same technique. As more people buy into UST, more luna would be depleted, making the remaining LUNA supply more valuable.
Do Kwon, founder of Terra also created the Luna Foundation Guard (LFG), a consortium whose job it is to protect the peg? The LFG bitcoin reserves had about $2.3 billion.
Their job was basically this- if $UST dipped below $1, bitcoin reserves would be sold and used to buy UST back. If UST goes above $1, creators would sell UST until it goes back to $1. The profit is used to buy more bitcoins to amplify the reserves.
How the crash happened
It all started on Saturday, May 7 when over $2 billion UST was withdrawn out of the Anchor Protocol by a supposed whale. That huge sale pushed the market price down to $0.91.
Using the $Luna burn mechanism, traders tried to take advantage of arbitrage, exchanging 90 cents worth of UST for $1 worth of luna. The dilemma led to a fall in the price of $UST and an increased supply of Luna.
The situation forced the Luna Foundation Guard to sell their bitcoin reserve in a bid to restore the $UST peg. However, it was short-lived as $UST didn’t meet the $1 peg and there was still an opportunity for traders to exploit the arbitrage.
The point where it got worse was when a lot of traders burned more $UST for $LUNA which led to a massive increase in the total supply of $LUNA. Existing holders started selling their $UST out of fear. And, the conundrum led to a massive joint plummet in the prices of both the $LUNA and $UST.
The two coins have been on a downward spiral in the last week. According to data from Coinmarketcap, $UST has gone too far below the $1 peg and it currently sits at $0.14. $LUNA has crashed to almost zero, with a market price of $0.000178, it is 100% down from the ATH of $119 it attained a month ago.
The series of events led to the Terra network stopping the processing of transactions twice in 24 hours on Friday. Binance, the world’s largest exchange, also delisted UST and LUNA but later listed them when the network resumed transactions.
Why is this important?
The collapse of the Terra ecosystem, including UST and LUNA, will go down as one of the most painful and devastating chapters yet in crypto history.
According to Coindesk, over $40 billion in crypto value has been wiped out through the LUNA and UST episode alone. Consequently, there have been reports of self-harm by those who had investments in Luna and savings in UST.
The collapse of the UST stablecoin brings to the fore the vulnerabilities of stablecoins which could be exploited in other stablecoins.
It has also been said that these ugly events might lead to heavy regulations from powerful political forces and regulators. For instance, the Secretary of the US Treasury – Janet Yellen already called for regulations. Last Tuesday, she said UST’s de-pegging “simply illustrates that this [stablecoins] is a rapidly growing product and there are rapidly growing risks.”
The way forward
Last Friday, Do Kwon said he had a plan to restore Luna’s value and re-peg UST. The Terra Labs CEO suggested forking terra, which means creating a new blockchain. Changpeng Zhao (CZ), CEO of Binance is sceptical about the plan. He questioned the idea of hard forking the Terra blockchain as a means to revive the ecosystem.
While pointing out the issues with the proposed plan, he said : “Minting, forking, don’t create value.”
He however recommended buying back and burning as an ideal way to revive the token’s market value. Yesterday, Do Kwon came out with a new “Revival Plan” to save the Terra ecosystem. In a post and Twitter thread, Kwon proposed forking Terra into a new chain.
Holders of LUNA on the ‘Classic’ chain (the existing chain) would receive an airdrop of the new chain’s token under the plan. The old chain will continue to operate using the newly renamed luna classic (LUNC) token.
Furthermore, Kwon said the new chain will be fully community-owned and Terraform Labs will not be eligible to receive funds in the initial token disbursement.
Kwon promised voting would begin on May 18. The plan is expected to go into effect if it is voted through by token holders. According to his proposed timeline, the new network launch could come as soon as May 27.
The total collapse of the Terra Luna/UST ecosystem caused a significant crash in the pricing of the bitcoin and the entire crypto market took some pretty hefty losses. In turn, this has led to many market pundits writing crypto off, and some suggesting that it could all go to zero.
However, this isn’t the end of the road for Terra. With the restoration plans that have been rolled out by the team coupled with the help and support of influential crypto figures like CZ, the Terra ecosystem will be back stronger.
According to CZ while showing support for the Terra community: “Failures can/will happen. But when they do, transparency, speedy communication and owning responsibility to the community is extremely important.”
CZ hopes Terra can rebuild itself “in a proper and sensible way.” Regardless of the decision Terra chooses to employ, the CEO plans to “support the community in any way we can.”
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