The Collapse of Terra and Luna
What Is a Stablecoin?
TerraUSD belongs to a class of cryptocurrencies known as algorithmic stablecoins. Unlike some other cryptocurrencies like Bitcoin or Ethereum, stablecoins are currencies designed to maintain their value. There are different methods of doing this. Four main types of stablecoins that exist and are fiat-backed, commodity-backed, crypto-backed, and algorithmic. Fiat-backed stablecoins use fiat currency to maintain their value (this is known as pegging). For example, Tether, which is currently the largest stablecoin, keeps a reserve of US dollars: for every Tether token, there is a dollar to back it up. This keeps Tether’s value fixed at $1.00 because investors can always exchange it for a dollar from the reserve. Commodity-backed and crypto-backed stablecoins also work similarly, but are pegged to the value of a commodity or another cryptocurrency, respectively. However, algorithmic stablecoins are different in that they have no backing asset. Instead, they use computer algorithms and smart contracts to control the number of coins in circulation. For example, when lots of people want to buy into a coin and not many people are selling it, the price of the coin will go up. To keep it stable, new coins are minted so that supply will go up to match the demand, bringing the price back down.
TerraUSD and Luna
Created in 2018, TerraUSD (UST) was an algorithmic stablecoin pegged to the US dollar. It also had a sister cryptocurrency called Luna (LUNA), which was created for the purpose of keeping UST stable. When UST went over $1, the Terra platform’s smart contract would allow people to trade $1 worth of Luna for 1 UST. Because the price of UST is over $1, people are motivated to make this trade because of the small profit that comes from it. The Luna would then be burned (taken out of circulation) while the UST would be newly minted, increasing the supply of UST and decreasing the supply of Luna. Traders would keep doing this and increasing the supply of UST until its price is brought back down to $1. The trade goes the other way as well: when UST’s price is under $1, people can make a profit by trading 1 UST for $1 worth of Luna. Here, UST is burned and Luna is minted until UST’s price is brought back up to $1. However, this meant that technically, Luna could continue to be minted without a limit. And exactly that happened on May 11, 2022.
The Crash
Starting May 7, several large holders of TerraUSD withdrew their money. Seeing this, many investors were frightened and hurriedly sold off their coins as well. Luna’s supply kept increasing to counteract this and maintain UST’s peg, but as its supply increased, its price decreased until its value dropped sharply by 97% on May 11. The algorithm wasn’t able to mint Luna fast enough to keep up with the rapid change, so there wasn’t enough Luna for people to be able to trade UST for it. As a result, UST lost its peg and fell down all the way to $0.27, never to recover. Afterward, most major crypto exchanges delisted both UST and Luna.
Starting May 7, several large holders of TerraUSD withdrew their money. Seeing this, many investors were frightened and hurriedly sold off their coins as well. Luna’s supply kept increasing to counteract this and maintain UST’s peg, but as its supply increased, its price decreased until its value dropped sharply by 97% on May 11. The algorithm wasn’t able to mint Luna fast enough to keep up with the rapid change, so there wasn’t enough Luna for people to be able to trade UST for it. As a result, UST lost its peg and fell down all the way to $0.27, never to recover. Afterward, most major crypto exchanges delisted both UST and Luna.
After the Collapse
TerraUSD was a large cryptocurrency, reaching a market capitalization of over $18 billion at its peak. As a result of the massive amount of money that investors lost during the crash, Do Kwon, one of the creators of Terra, came under heavy fire. He faced charges from both South Korean prosecutors and the SEC in the United States, and was arrested in March. The collapse also led to a panic throughout the crypto market, as many investors lost confidence in the asset class as a whole. To this day, it serves as a reminder that cryptocurrencies are risky to invest in, even if they claim to be stable.