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Why Terra LUNA and UST crash?

03 Aug 2022 By : Sanskar Ranka
Southeast Asia’s Lar

The cryptocurrency community never expected to ask whether TerraUSD (UST) or LUNA would hit $1 first. Recently in mid of May, the dramatic drop of a stablecoin named TerraUSD and Terra Luna rattled the entire crypto market, and other tokens such as bitcoin and tether also struggled. Terra Luna is currently almost useless. 

Some have also connected this crash to the financial meltdown of 2008. After all, it is the darkest moment in the crypto-verse since the bankruptcy crisis that forced the closure of the Mt. Gox exchange in 2014.

But what actually happened? What impact will this have on the rest of the crypto ecosystem? What is Terra, and why does it have a sister currency named Luna? Here's everything you need to know.

What are Terra LUNA and Terra USD(UST)? Mechanism of Terra

Following this crash, there is uncertainty among cryptocurrency enthusiasts; many of them called it the Luna crash, and some called it the Terra crash. Even though it is a stablecoin, UST also crashed. Let’s clarify this-

Terra is a blockchain network that focuses on producing stablecoins. Technically, Terra is the crypto asset, while LUNA is the sign for its native cryptocurrency. Terra’s ecosystem is composed of two different types of tokens: LUNA and a group of stablecoins.

Stablecoins from the first generation, like Tether, keep their value by leveraging a variety of assets, including fiat reserves. However, some supporters of decentralization contend that having a single body in charge of a collection of physical assets creates a single point of failure. Risks such as opaque governance structures and the question of whether the reserves held to correspond to those declared are brought about by this, which focuses regulatory attention.

Decentralized stablecoins attempt to overcome these governance problems by keeping their pegs through algorithms as opposed to huge currency and debt reserves. One such algorithmic product is TerraUSD (UST), created by Terraform Labs.

UST is an algorithmic stablecoin in the ecosystem of Terra. Unlike fiat-backed stablecoins like USDC and BUSD, UST is not backed by physical assets. Instead, UST uses algorithms to keep its value pegged to $1 and is backed by a sister token called LUNA.

When the price of UST increases too much, its algorithms create additional LUNA to reduce the price, or the opposite if the price decreases too much. LUNA is intended to act as a sort of price shock absorber for UST. 

Just like any other stablecoin, users must be able to exchange one UST (even if it is worth less than $1) for one LUNA for this mechanism to stabilize the price to function.

Luna’s work in the Terra ecosystem

Terra's native token, LUNA, serves four functions in the Terra Protocol:

  • A mechanism for absorbing demand variations for Terra-minted stablecoins to keep price pegs.

  • A way of paying Terra network transaction fees.

  • A mechanism to participate in the platform's governance structure by developing and voting on Terra Protocol amendment proposals.

  • Terra's delegated proof-of-stake (PoS) consensus method was built to simplify network transaction validation.

You'll need to mint some UST before you can buy it. You'll pay the going fee in LUNA to do this. The protocol takes those LUNA and burns them, reducing their availability and somewhat raising the price of LUNA. The process is the same in reverse; you must convert UST stablecoins to manufacture LUNA.

By exchanging LUNA for UST when the price of UST is less than $1 and purchasing LUNA when the price of UST is greater than $1, traders can benefit from slight price differences which also help to control the price of UST. For example, traders can buy a large quantity of UST for $0.7 and then sell it for $1 of LUNA. By doing this, the supply of UST is decreased, which causes the price to rise once again.

The same mechanism supports Terra's other stablecoins. The elasticity of LUNA's supply, according to Terra's, ensures that the stablecoins will never get out of balance. However, these claims were no longer valid when the LUNA and UST crashed to 99% of their value.

Let's get into the fundamental reasons why the LUNA and UST collapsed

Why did Luna and UST crash?

All stablecoins require a utility to support their peg. The utility of UST is derived from Anchor Protocol, a decentralized finance (DeFi) application. Anchor pays around 20 percent interest to be a savings account for your TerraUSD, which is a fantastic value. Many simply put TerraUSD in an Anchor account and watch the 20% yield roll in, around 70% of the TerraUSD in circulation was put in Anchor.

However, Anchor passed a motion in March of this year to switch out the 20 percent charge for a variable rate. Then, significant sums of TerraUSD were removed from Anchor, which alarmed traders and led them to sell their TerraUSD and Luna tokens. UST worth over $2 billion was withdrawn from Anchor Protocol, and a large portion of that was sold right away. 

Users can always exchange 1 UST for $1 worth of LUNA, even if the value of 1 UST is less than $1, which is a requirement for the UST's price stabilizing mechanism. To benefit from this mechanism, numerous traders sought to exchange 90 cents in UST for $1 in LUNA.

Ultimately, TerraUSD and Luna's delicate balancing act fell apart. People started escaping by burning TerraUSD in exchange for Luna. The price of Luna fell as the quantity grew exponentially. Luna was effectively thrown off the balance scale. As more people attempted to sell their TerraUSD, the balance system failed, causing TerraUSD to fall along with Luna. 

The aftermath of the collapse

After the Terra ecosystem collapsed, a lot of developers, communities, investors, and families were heartbroken. Some people lost their life savings, and there have been allegations that many traders committed suicide also. The market has yet to rebound as a result of the crash's impact on Bitcoin and other significant cryptocurrencies.

LUNA was taken out from the list of numerous significant cryptocurrency exchanges, including Binance, OKX, and CoinDCX. Additionally, because of security concerns, operators have frequently stopped the Terra blockchain, and many Projects of NFTs and metaverse from Terra are shifting to the Polygon and other networks.

Ryan Wyatt, the CEO of Polygon, was overjoyed expressing in an earlier tweet that the network could support lots of projects at once. The CEO highlighted his pleasure that developers who did get unemployed following Terra's mishap can now put their skills to work again.

Polygon Studios offered a multimillion-dollar fund in May to aid Terra projects considering a switch. It was prepared to spend up to $20 million to assist Terra teams in switching to Polygon's blockchain so they could continue developing products.

Following the collapse, the Luna Foundation Guard (LFG), a company-created fund that had more than $3 billion in Bitcoin reserves, attracted a lot of attention. The Terra USD algorithmic stablecoin received assistance from the BTC fund to keep its balance.

The corporation said that in an unsuccessful effort to stabilize UST, it used up all of its BTC reserves.

The corporation Terraform Labs has also been the subject of legal action as a result of the huge losses suffered by enraged investors in the aftermath of the Terra collapse. The South Korean government was committed to its mission to punish Terra's offenders. Over 200,000 South Koreans are said to have suffered losses when Luna and UST filed for bankruptcy. Following the start of inquiries into Terra's demise, authorities then concentrated on Terra's development team. They also imposed a travel ban on the developers and employees of Terraform Labs. 

The failure of the $40 billion Terra ecosystem not only left the project's creators in legal trouble but also forced governments throughout the world to rethink their approach to regulating cryptocurrencies. Japan passed new laws restricting stablecoin issuance to banks and trust companies, and Korea formed a new cryptocurrency monitoring body.

Will LUNA Recover?

Although there is a chance that the token may rebound, everything is still quite unpredictable right now. Burning a significant portion of the supply to return Luna's worth to pre-crash levels would be the only option for it to approach its previous price. Although Terra has stated that it is a part of the recovery strategy, it might not even be feasible.

Do Kwon, the founder, and CEO of Terraform Labs placed a strong emphasis on maintaining the community and developers who contribute to the value of Terra's block space and on building an agreement to find a way to rise again.

In a fresh proposal made by Kwon, the Terra blockchain undergoes a hard fork, resulting in the release of Terra 2.0 and the renaming of the existing luna coins as luna classic (LUNC). With a 65.5 percent majority, Kwon's fork proposal has been approved.

Kwon's snapshot for Terra 2.0 outlines the chain upgrading process and specifies that the algorithmic stablecoin will not be used to produce the new Terra. 

The previous blockchain has been rebranded by Luna Classic, while the newer one is called Luna 2.0. Several once-dominant DeFi programs on Terra are getting have already joined the new 2.0 system. Despite a fresh upgrade, a new network, and a new token, it hasn't received as much support as it had in the past. 

At present, Luna Classic is not showing any signs of recovery. According to a Technical analysis of Terra from CoinGabbar Terra's LUNA price could continue falling, but at the current time, placing an entry is ill-advised.

Conclusion

The meltdown has also raised questions about the whole cryptocurrency market. Now it is evident that even stablecoins who live up to their claims of stability are not stable. The UST and LUNA situation highlights the danger of algorithmic stablecoins and the value of diversity in the cryptocurrency sector.

In the future, it could take some time for the larger cryptocurrency market to recover from the collapse of the Terra Ecosystem. The cryptocurrency community is still growing and learning despite setbacks. Events like the collapse of UST serve as important lessons for the developing industry and may enable the development of more safe and stable cryptocurrency initiatives.

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