Why did TerraUSD and Luna Crash?

The value of Luna plunged sharply on Wednesday, from $6.75 to a little over $1. As of Thursday afternoon, the currency was worth only $0.02. The sibling token of the controversial stable currency TerraUSD is now effectively worthless.

According to Coin Gecko statistics, Luna fell to $0 on Friday, a remarkable decline for a cryptocurrency formerly valued at more than $100.

TerraUSD, sometimes known as UST, is designed to be tied to the US dollar one-to-one. When the UST decoupled from the dollar earlier this week, values plummeted. UST has lost its peg and was trading at 12 cents on Friday, according to statistics.

Traders prefer to acquire currencies such as Bitcoin, Ether, and Dogecoin using digital assets tied to the dollar since only the price of the crypto asset changes when they buy or sell.

Stablecoins Rise in Popularity

Stablecoins enable quick trade without the lengthy settlement timeframes associated with government-issued currencies, which might take days. If a person wants to sell Bitcoin and immediately lock in their dollar winnings, they might do so by purchasing a stablecoin on major cryptocurrency exchanges.

UST and Luna are connected. UST is referred to as an algorithmic stable currency, which means there is an expectation that its $1 peg will be managed by the underlying code. This is fundamentally different from other stable currencies, such as tether and USDC, which are backed by real-world assets like bonds. UST has no real-world reserves.

Algorithmic stablecoins are not backed by assets, instead relying on financial engineering to maintain their ties to the dollar. Previously, the algorithmic stable currency TerraUSD kept its $1 price by depending on traders to perform an arbitrage function between Terra and Luna values.

When Terra went below the peg, merchants would "burn" the stablecoin, taking it out of circulation by swapping TerraUSD for $1 worth of fresh Luna units. This move lowered TerraUSD's supply and increased its price. When the value of TerraUSD soared beyond $1, traders might burn Luna and generate new TerraUSD, boosting the supply of the stablecoin and bringing its price back down to $1. Traders said a series of significant withdrawals from Anchor Protocol, a crypto bank established by developers at Mr. Kwon's business Terraform Labs, was the cause for the decline. It began during the 7-8 May weekend and spiralled out of control the following Monday. Digital currency investors use such services to earn interest on their coins by lending them out.

The Anchor platform held most of the stablecoin's supply. According to the platform's website, investors had invested more than $14 billion in TerraUSD in Anchor by early May. Large trades eroded TerraUSD's $1 value during that May weekend.

Because of the volatility, many investors withdrew their TerraUSD from Anchor and sold the coin. As a result, additional investors withdrew from Anchor, causing a chain reaction of more withdrawals and selling. TerraUSD deviated from its dollar peg as the supply-demand equilibrium was disrupted. Luna, its sister coin, has also seen its value fall. The crypto community speculates that an anonymous trader triggered the run as part of an "attack" on the stable currency.

Anchor TerraUSD Deposits Drop

According to the company's website, Anchor's TerraUSD deposits had dropped to around $1.6 billion on 13 May. The Terra blockchain, which underlies UST and Luna, has also stopped processing transactions twice in less than 24 hours, adding to the problems. Before the catastrophe, $14 billion in TerraUSD was placed in Anchor. There is less than $200 million remaining.

The Luna Foundation Guard may be running out of funds as well. Its crypto reserves are down to less than $90 million, and it has no Bitcoin in its wallet. The breakdown also impacted the Terra blockchain, which was momentarily unavailable on Thursday "to avoid governance assaults".

Meanwhile, Binance, the world's largest cryptocurrency exchange, delisted UST and Luna on Friday. Many traders have sold, believing that the assets would not be able to recoup their losses. Even Bitcoin fans have expressed concern.

Nonetheless, the collapse spread. Luna's Bitcoin hoarding spread to other cryptocurrencies. Traders anticipating a TerraUSD breakdown appear to have sold Bitcoin, leading to the token's falls. This, in turn, undermined demand throughout crypto markets, which lost more than $400 billion in market cap as several tokens, including Bitcoin, Ether, Cardano, and Solana, fell by more than 20%.

The incident has also drawn policymakers' attention back to the absence of regulation around stable coins and the larger cryptocurrency sector. As TerraUSD broke from its peg on 10 May, Treasury Secretary Janet Yellen reiterated her appeal for Congress to establish laws governing stable currencies.