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Analysing UST and $LUNA’s Collapse: What Happened, Why It Happened and Looking to the Future

‘The crypto market is extremely volatile’ – this is a statement most, if not all, in the fintech sphere have heard. In May, the severity of a volatile market came to light when TerraUSD (UST) and $LUNA (Luna), its sister token, collapsed seemingly overnight. Within the space of a few days Luna’s price dropped from $82 to $0.000017. But what caused this catastrophic crash and what does it mean for the future of crypto?

This has been the worst crash the crypto market has seen since 2020, when Bitcoin hit $3,850 in March. Fear has been a constant through both market crashes, though the reason for this fear was slightly different: in 2020 the outbreak of Covid-19 sent the world into turmoil, whereas the reasons for this crash are slightly less clear. Some have suggested it was a reaction to a volatile period in the market and the rising interest rates, whereas others have speculated that it was a direct attack on the Terra blockchain.

Why did Terra suffer so immensely?

There are a few important things to note about UST and Luna that separate them from other tokens and stablecoins:

  • UST is not a stablecoin pegged to the US dollar, rather it is an ‘algorithmic’ stablecoin, meaning it keeps its stable value with billions in Bitcoin reserves, which ensures the value never inflates or deflates above or below $1.
  • In order to create UST, you need to burn Luna.
  • According to Coindesk, almost 75 per cent of the total Terra circulation was deposited in the Anchor Protocol.
  • The Anchor Protocol provided investors with almost 20 per cent interest rates.
  • Only $100 million worth of UST can be burned for Luna per day.

UST retained its peg by allowing investors to exchange it for Luna – no matter the price of UST, it could always be traded in for $1 of Luna, allowing investors to profit should UST ever waver from its $1 value.

On 7 May, more than $2billion was removed from the Anchor Protocol which caused UST values to drop by nine cents. With many looking to capitalise on this, investors flocked to exchange their UST for Luna, however, upon reaching the cap, they began to panic and sell off their UST. This panic snowballed, causing UST’s value to drop below 50 cents. Luna suffered the most as a result of this with its value dropping to a fraction of a cent.

The Terra ecosystem’s collapse had a knock-on effect on the rest of the crypto market:

Victoria Scholar, head of investment, interactive investor
Victoria Scholar, head of investment, interactive investor

Initially analysing the impact on the crypto market, Victoria Scholar, head of investment, interactive investor said: “Cryptocurrencies are plunging with bitcoin down by more than 12 per cent today against the US dollar at the time of writing according to Coinbase. Bitcoin has broken below $28,000 and is on track for its seventh consecutive weekly decline. Since the March peak it is down by more than 40 per cent and has shed around 60 per cent since the November high.

“Shares in Coinbase are trading sharply lower pre-market having slumped 26 per cent yesterday (11 May) on the back of a weak first quarter scorecard in which the crypto platform reported a loss of $430million, almost ten times bigger than analysts’ expectations. Its guidance was also disappointing with Coinbase warning of softer trading volumes and user numbers this quarter, as the crypto sell-off takes its toll. The stock is down by more than 85 per cent from its opening price from April 2021 on its first day of trading as a public company.”

Susannah Streeter, Senior Investment and Markets Analyst, Hargreaves Lansdown
Susannah Streeter, Senior Investment and Markets Analyst, Hargreaves Lansdown

Susannah Streeter, senior investment and markets analyst, Hargreaves Lansdown added: “Hopes that Bitcoin would act as an inflation hedge have fast evaporated as the cryptocurrency has lost more than half its value since its November high, as consumer prices have soared. This most recent price spiral downwards appears to have been sparked by the dramatic fall in value of the TerraUSD stablecoin, designed to trade one on one against the dollar-snapping off its peg, whipped by winds of panic rushing through the crypto world.

“We’ve had warnings time and time again from the financial watchdog, the Financial Conduct Authority (FCA) that investors risk losing all their money if they invest in the crypto wild west and the red flags it’s been waving have been shown to be prescient given the downwards rollercoaster ride crypto is currently on. The FCA reserved its most recent warning this week for NFTs, tokens that have been snapped up by speculators on a wave of euphoria, which are now crashing back down to earth. It’s a timely reminder that investors who dabble in such risky assets have very little protection, as they are not regulated beyond anti-money laundering legislation. There have been examples of hackers gaining access to keys to digital wallets and those taking the plunge have very little recourse to action should anything go wrong.”

Looking to the future
Nick Saponaro, CEO, Divi Project
Nick Saponaro, CEO, Divi Project

Nick Saponaro, CEO, decentralised payment ecosystem, Divi Project said: “Exchanges make more money during a market crash than they do when we’re in a full-on bull run. Being both the entry and exit point for the majority of people has its benefits. Many DeFi protocols are based around stablecoin yield, tokens are suffering of course, but generally no negative impact to the sector at large. NFTs are holding their ETH value for the most part and we haven’t seen a major decline there yet.

“No one is concerned. Builders will keep building and most of us have been through multiple bear markets at this point. In times of decline you must ask yourself, has anything fundamentally changed about this asset class that should change my investment thesis? The answer here is no, especially from a long-term view.”

 Viktor Prokopenya, London-based fintech investor
Viktor Prokopenya, London-based fintech investor

London-based fintech investor Viktor Prokopenya spoke about the importance of regulation saying: Regulation will bring transparency to the market and end bad practices. Like all young technologies – crypto is only about a decade old, the industry has to grow up and out of its existing ways. The recent collapse of Terra and Tether and other stablecoins have shown a lack of transparency and an ironic ‘instability’ in a supposedly more ‘stable’ cryptocurrency.

“I, along with others, have been a strong proponent of regulation of the crypto industry and this situation is one that could have been avoided with stricter rules and compliance criteria. Crypto needs to shed its volatile image and I am heartened to see that the UK is speeding up its plans to regulate the crypto market in light of this crash. There will necessarily be trial and error involved in this process with some pitfalls along the way, however, it is a necessary step for crypto to ‘grow up’ and gain legitimacy and I am committed to using my expertise to work with policymakers in guiding this process.”

Author

  • Francis is a junior journalist with a BA in Classical Civilization, he has a specialist interest in North and South America.

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