Over the last few weeks, the cryptocurrency world has been viewed as the Crypto’s Lehman Brothers moment due to the collapse of a stablecoin called TerraUSD and its sister currency Terra Luna. Here is everything you should know for people wanted to understand it quickly.
What are TerraUSD and Terra Luna?
Terra, prior to its demise, was one of the most promising and ambitious crypto ecosystems with one key mission - to build the largest algorithmic stablecoin.
TerraUSD (UST) was an algorithmic Stable Coin designed to keep a 1-to-1 peg with the dollar as opposed to USDT backed by actual USD reserve. The peg is maintained by an arbitrage mechanism with a related cryptocurrency, Terra Luna (Luna). While 1 unit of UST is always supposed to be worth exactly $1, the value of Luna can fluctuate. Essentially, Luna acts as reserve or counterweight to maintain its dollar peg. Burning (permanently destroy) 1 UST always give you (mint) $1 worth of Luna, vice versa. Here is how the arbitrage mechanism works:
When UST falls slightly to $0.99 and arbitrageurs know burning one UST always gives you $1 worth of Luna. Arbitrageurs will then buy 1 unit of UST at $0.99 and burn their UST to mint $1 worth of Luna and earn a profit. These arbitrage transactions will eventually raise the UST’s price back to $1.
When UST increases slightly to $1.01, arbitrageurs will buy $1 worth of Luna and burn their Luna to mint $1 worth of UST and sell it at $1.01 to earn a profit. These arbitrage transactions will eventually push the UST’s price back to $1.
Essentially, LUNA tokens act as collateral for UST and UST is intended to maintain stability through a 1:1 mint and burn ratio with LUNA.
Collapse of LUNA and UST
Basically, the balance between UST and Luna broke.
What makes UST valuable is the confidence in it. When you think everyone else treats UST as worth a dollar, you won't sell it for $0.9 in a panic. But if you think everyone else will treat UST as worth zero, then you will dump it as fast as you can no matter what price you can get.
One of the most important people held UST was because of the Anchor Protocol. It's like a savings account for you to keep your UST that pays you 20% interest. However, Anchor has passed a resolution to replace the 20% rate with a variable rate in March. This shook the confidence of the pool’s liquidity providers.
The de-peg began on Saturday, May 7th. It was catalyzed by the withdrawal of $150M UST from the Curve Wormhole pool by Terraform labs to prepare for the 4pool launch. This was followed by a large $350M sale of UST for USDC that caused people to believe that the market cap of Luna is smaller than the market cap of UST, which means UST no longer worth $1.
People started dumping UST by burning UST to mint Luna and purchase safer assets (“Flight-to-safety”) causing a plummet for Luna and UST.
LUNA has fallen 99.9 percent from it's all-time high, trading at $0.00013973 at the time of writing. It's all-time high was $119.18 on April 5, 2022.
This selling pressure on UST led to a reflexive downwards spiral, commonly known as a “death spiral”.