LUNA and TerraUSD Collapse. What Awaits Us Next?
One of the most popular Terra stablecoin (UST) lost its peg to the dollar, and its sister cryptocurrency LUNA collapsed by 99% in a week. This crisis caused panic in the crypto market, as it is one of the first cases of stablecoin collapsing to zero.
We analyzed the situation. This article will help you understand the problem and evaluate objective analytical predictions.
UST is a stablecoin that is part of the Terra blockchain project. It is pegged to the price of an underlying fiat currency such as the dollar. However, Terra has no specific assets or cash held in reserve to support UST, unlike other cryptocurrencies. The coin’s peg to the dollar is not backed by centralized entities such as Tether (USDT). The mechanism requires burning LUNA to create UST and vice versa.
Terra described its goal as creating a bridge between traditional finance and cryptocurrencies. The UST and LUNA interaction algorithm is responsible for the 1:1 rate matching. Because of this, UST is called an algorithmic, or decentralized, stablecoin.
However, on May 9, 2022, the algorithm-based Terra blockchain UST stablecoin lost its peg to the U.S. dollar and plummeted in value. In the last 36 hours, this stablecoin has fallen by more than 90%, although previously, it was stable at 1:1.
Against this backdrop, the cryptocurrency LUNA, the foundation for the UST algorithmic stablecoin mechanism, plummeted in value. The value of the LUNA coin fell even further, from $80 to $0.1 within two days.
LUNA became the first coin to rank among the top 10 cryptocurrencies and then depreciated by 99%. As a result, investors are actively withdrawing funds from this Terra blockchain service token because of the collapse of the core ecosystem model.
The collapse of TerraUSD and LUNA robbed investors of tens of billions of dollars. The community is actively looking for the culprits of this crisis, as simple market factors could not lead to such a situation.
Several external and internal reasons probably contributed to this situation. Let’s look into this in more detail.
What Caused LUNA and UST to Collapse?
According to Investing.com, the collapse could be a carefully played scheme by several “whales”. That is significant cryptocurrency funds that managed to take advantage of a seemingly stablecoin and earn in the fall.
The initial reason for the decline of UST to 0.98 USD and below were indeed a sell-off in the cryptocurrency market and the actions of an unknown seller who sold $300 million worth of stablecoin on May 8. It was probably accompanied by provoked discussion of UST’s weakness in social networks, which led to panic and significant pressure from other market participants. For some time, market makers tried to restrain the UST rate by selling Bitcoin and other crypto-assets, but it didn’t save the situation.
So far, there is no reliable information about who sold UST in huge volumes, which led to the decline in value. Experts believe it could only be a large fund or an institutional investor with more than $3–5 billion in crypto assets. The purpose of the sale was probably to make money on short trades. Whoever set this process in motion knew about the vulnerabilities of algorithmic stablecoin.
But why did high volume UST sales lead to the collapse? Doesn’t stablecoins algorithms take such situations into account and don’t react to sharp sell-offs?
The answers to these questions lie in the shortcomings of the Terra algorithm itself, which is used in UST and the LUNA token. As it turned out, the system has a number of flaws that have not withstood the high load.
The Terra blockchain has implemented an unusual algorithmic way of pegging to the dollar. The smart contract system allows a lot of new UST tokens to be quickly issued in exchange for burning Luna cryptocurrency when there is increased demand for TerraUSD. This raises the price of Luna and lowers the price of UST if it suddenly rises above $1 due to a spike in demand. However, the algorithm also works in the opposite direction. If the UST falls below $1, the system generates a new Luna to buy back the cheaper UST. This reduces the Luna price due to supply inflation but pushes the UST price to $1.
For USTs to fully dominate the market, people need to own the asset en masse. That is the purpose of Anchor’s launch as a virtual crypto-bank, which allows some people to borrow in UST and others to make deposits. The UST stacking yield was 20% per annum. As a result, the value of the cryptocurrency LUNA grew as UST demand grew as a lucrative investment instrument. However, this growth on both sides was artificial. Any disruption in the supply-demand ratio could lead to a collapse.
Monetary reserves in the Anchor system continued to decline due to high APY stacking and constant artificial maintenance of the UST exchange rate. Because of this, the project’s founders were forced to announce a 1,5% monthly reduction in the project’s yield from March 2022. Then UST deposits began to decline, which led to an outflow of investments. As a result, money became scarce, and the subsequent major sell-off on May 8 was the beginning of the collapse.
How Will The Luna And TerraUSD Crisis Affect The Cryptocurrency Market
It is possible to keep savings in stablecoins, but one should analyze how these assets are secured. If they have a transparent structure and 100% absolute asset backing in cash or cash equivalents, they are safer and more reliable than algorithmic stablecoins.
Based on this situation, we see that crypto-assets need a better classification. Experts already believe that it would help separate different types of coins and eliminate the substitution of concepts used by marketers in the crypto industry.
An even deeper correction in the cryptocurrency market likely awaits us soon. Bitcoin is always an indicator of investor sentiment. At the moment, its value is gradually decreasing, and at the moment of writing this article, its value is $28,000.
There are preconditions that the correction in the crypto market will continue for some time. Based on this, investors and users should expect a good time to buy at a lower price, as the value of the top 10 cryptocurrencies can recover by fall and winter, as evidenced by the overall fundamental picture, technical analysis data, and expert opinions.
We are witnessing a deep correction in the cryptocurrency market, partially triggered by unscrupulous whales. It is likely that under the influence of this crisis, new requirements for the most vulnerable assets will be developed, and regulators’ actions will be strengthened. However, the most stable coins like USDT will not be affected.
The cryptocurrency market has grown too fast. Over the past year, it has grown in part due to technologies such as NFT and algorithmic stablecoins. However, marketing tricks and the substitution of concepts in regulation have shown that the market is not ready for rapid development. Moreover, the technology of some blockchain projects is too weak to withstand pressure or attacks from large institutional investors. Who knows what other coin the next fund or billionaire will want to short?
So keep an analytical approach to choosing investment projects. The potential of the cryptocurrency market is only 10–15% explored. A temporary correction is only a step towards further growth and rapid development of decentralized finance.
What the Founder of Terraform Labs Do Kwon Says?
TerraUSD, like many other Stablecoins, belongs to a certain company. In this case, all rights to this coin belong to Terraform Labs. The founder of this company, Do Kwon, has published a new proposal to return his stable UST ecosystem coin to the $1 denomination.
“I understand that the last 72 hours have been extremely difficult for you. However, I am determined to work with you to overcome this crisis, and we will find a way out of it.”
To lock UST back in at $1, Kwon suggested increasing the market supply of LUNA to absorb any attempts by investors to dump UST. It would not allow the value of LUNA to rise to its previous level but would stabilize the situation.
Do Kwon also said that if TerraUSD (UST) returns its fixed price of $1, it will exit the current minting and burning mechanism and “switch to a collateral mechanism”.
It will require Do Kwon’s team to manually increase the performance of the Anchor protocol to increase LUNA issuance several times over. It is not yet known when this mechanism will be implemented or how successful it will be.
The LUNA and TerraUSD crisis provoked panic among many investors and users of the cryptocurrency market. Moreover, other algorithmic stablecoin projects that are not backed by specific assets are at risk of losing their peg to the dollar. All this is happening against the backdrop of the fall of bitcoin itself, which has lost more than 20% of its value since the beginning of the month and has fallen below $30,000 for the first time since last year.
We need to remain vigilant and wait for the best moment to return to investing. We believe that a deep correction in the crypto market is a great opportunity to open profitable long-term deals. Stay optimistic. Stay with Trustee Wallet.