Terra’s LUNA Crashed. Over $40 Billion Lost. Here’s Why.

The catastrophic crash of Terra’s LUNA is the biggest story in cryptocurrency right now. In roughly one week’s time, the price of LUNA plummeted from over $82 to under $0.01. The collapses of LUNA and UST – the stablecoin associated with Terra – resulted in losses of over $40 billion for the project and its investors.

In cryptocurrency as well as the rest of life, the harshest failures often produce the most important lessons. In this sense, the story of Terra’s failures are no different. Through examining the crashes of LUNA and UST, we can learn a lot – especially about red flags in potential investment opportunities. Of course, in order to gain as much wisdom as possible, we have to dig as deep as possible.

With that goal in mind, let’s go back to the start.

What are Terra, LUNA, and UST?

Especially for those who already understand a bit about cryptocurrency, the best way to understand Terra, LUNA, and UST is to compare them to other more well-known projects.

Terra: Terra is the name of the blockchain network – or “ecosystem.” The project in question is referred to as Terra, in the same way that we refer to Ethereum’s network as the Ethereum blockchain.

LUNA: LUNA is one of the native tokens of the Terra blockchain network. Continuing with the Ethereum comparison, LUNA can be compared to ETH.

UST: UST is another native token of Terra. Unlike LUNA, however, UST’s inherent goal is to act as a “stablecoin,” which means that its price was intended to remain constant. UST was not supposed to be worth much more or less than $1.

With these simple definitions out of the way, we can move on to understanding why Terra attracted investors and gained value in the first place.

What Attracted Investors to Terra?

Before the monumental crash, Terra appeared to be a robust and impressive project to many investors. In fact, LUNA enjoyed a meteoric rise from less than $0.50 to over $110 during the Terra network’s first 2 years.

Although this article is focusing on LUNA and UST, specifically, it’s worth noting that the Terra blockchain was utilized to build over a hundred decentralized apps and host a variety of algorithmic stablecoins. Like many other cryptocurrencies, Terra functioned with the goal of facilitating peer-to-peer transfer of payment, as well.

While Terra appeared to have many interesting offerings to users and investors alike, one of its most attractive features was the “Anchor Protocol.” Anchor promised 20% APY to individuals willing to hold UST for extended periods of time

20% APY is an incredible return – especially when it’s guaranteed. The guarantee of 20% APY brought huge investments of capital in return for UST. This attraction of investors to Terra – and UST – was instrumental. UST needed to maintain a large supply so that the mechanism by which UST aimed to achieve stability – through LUNA – could function.

How did LUNA and UST Function Together?

While other stablecoins, like Tether, strive to maintain stable prices through the usage of collateral, UST aimed to utilize another cryptocurrency – LUNA – to keep its price stable at $1. The relationship between LUNA and UST depended on a simple promise: $1 of LUNA could always be exchanged for 1 UST.

The goal of keeping UST at $1 was to be achieved through two mechanisms: one to decrease UST’s price when it got too high and one to increase UST’s price when it got too low.

When UST’s Price Rose Above $1.00…

Holders of LUNA would be incentivized to trade their LUNA for UST, because 1 UST would be worth more than their $1 of LUNA. When this action occurred, the LUNA traded for UST would be burned and UST would be created, resulting in an increased supply of UST. Increased supply means decreased price. As a result of LUNA holder’s burning their LUNA and increasing UST’s supply, UST’s price would fall back to its equilibrium point of $1.00.

When UST’s Price Fell Below $1.00…

The same mechanism that worked to decrease UST’s price worked in reverse, too. When UST’s price fell below $1, holders of UST would be incentivized to trade their UST for LUNA, since $1 worth of LUNA would be inherently more valuable than UST (at its sub $1 price). When this action was taken and UST was traded for LUNA, UST was burned while LUNA was created. “Burning” UST meant decreasing its supply. Of course, decreasing supply means increasing price.

These mechanisms worked quite well. Unfortunately, they only worked until UST was “depegged.”

How did UST “depeg”?

“Depegging” is perhaps the worst thing that can happen to a stablecoin. Stablecoins are said to be “pegged” to assets when they maintain equal price with said assets. When they fail to maintain that equilibrium, they can become “depegged.” Depending on how severe the depegging is and whether or not the situation can be corrected, depegging can mean total failure for a stablecoin.

In UST’s case, its depegging was triggered by a targeted attack.

What Kind of Attack Depegged UST?

The perpetrators of the attack on Terra, LUNA, and UST recognized a fatal flaw in the mechanism that kept UST’s price stable – and exploited it.

Recall that LUNA and UST used each other to keep UST’s price stable. UST’s price rising above $1 resulted in LUNA being burned while UST’s price falling below $1 resulted in UST being burned and LUNA being minted. In theory, this mechanism functions as long as the desired results – price equilibrium of UST – are achieved. But what happens if UST falls below $1 and cannot reach $1?

LUNA continues being minted, leading to its supply rising, leading to its price falling. Again, this isn’t a problem as long as UST reaches equilibrium. But when UST cannot reach $1, LUNA’s supply rises until it loses all of its value.

And that’s what happened on May 8, 2022 when attackers sabotaged UST’s liquidity.

How was UST’s Liquidity Sabotaged?

The attackers sabotaged UST’s liquidity by acting in the exact opposite way that the Terra network expected and incentivized individuals to. Whereas people were expected to sell UST only when it rose above $1, the attackers set out to sell UST continuously and mercilessly so that its price fell well below $1 and could not rise.

As you read about this attack, you may wonder how we know that it occurred. Actually, the immutable nature of the blockchain means that there are perfect records of the attack for anyone to review, should they wish to do so.

When we review the records of UST trades on May 8, we see huge sell orders of UST, even as it fell to $0.90. Of course, selling UST at $0.90 makes no sense; every sale of 1 UST for $0.90 is a loss of $0.10. From this logic, it’s easy to see that this was a premeditated, coordinated selloff and that the individuals executing it understood that they were selling UST at a loss, since they had a bigger goal: crushing UST and LUNA.

The losses incurred from selling UST at low prices represented a calculated risk; the attackers bet against the Terra ecosystem by “shorting” UST and LUNA.

What Happened Next?

The attackers’ plan worked. By selling off an estimated $2 billion of UST, they successfully depegged the “stablecoin” while plummeting the price of LUNA. 24 hours after beginning the attack, LUNA’s price fell by more than 50%. LUNA continued falling and falling, losing all of its value by May 12. Then, the developers behind Terra decided to “halt” the blockchain, essentially shutting down the ecosystem. $40 billion evaporated.

What Can We Learn from Terra?

The failure of LUNA and the loss of over $40 billion brought about some truly awful consequences. Among some of the most significant were:

  • A number of suicides, committed by individuals who lost life-changing amounts of money in the LUNA and UST collapses, were reported.
  • Confidence in stablecoins and cryptocurrency in general was significantly hurt, perhaps contributing to decline in crypto prices across the board.
  • Cries for increased regulation rang out from those both inside and outside of the crypto space.

The simplest lesson to be learned from the crashes of LUNA and Terra is a simple reiteration of a lesson most of us have already heard countless times:

If something seems too good to be true, it probably is.

Anchor’s promise of 20% APY brought in billions of dollars from investors. Unfortunately, this promise of 20% APY wasn’t sustainable.

Going forward, we’d do well to remember Terra’s promises every time we look at new opportunities with big promises. As we assess emerging cryptocurrency projects, we must temper our greed with our sensibilities. Generally speaking, the more excited people become by the lure of profits, the more irrational and less discerning they become, as well.

Increased rewards must come with increased risks. In the case of LUNA and UST, the rewards were high. As we’ve come to find out, though, the risks were higher.

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