Breaking Down the Basics

To fully understand what caused the Terra Luna crash, let’s look at how Terra Luna works. Terra Luna is a project which incentivizes network participants to balance Terra Luna’s algorithmic stablecoin – UST. UST is what is known as a Seigniorage algorithmic stablecoin, which is a specific type of algorithmic stablecoin.

Algorithmic Stablecoins

Many of us are familiar with traditional collateralized stablecoins; particularly those which are fiat backed, such as USDT and USDC. There is however an entirely different category of stablecoins. This variety of stablecoins – algorithmic stablecoins – are non-collateralized by nature and instead are balanced by computer algorithms that are designed to mimic the value of other currencies, such as fiat currencies.

These stablecoins are smart contracted and algorithmically generated. An algorithmic stablecoin system will increase and reduce the number of coins in circulation, to match the price to that of which it represents. The system will remove tokens when the stablecoin falls below the price of the asset and will add tokens when the stablecoin increases in value. This target price is known as the “peg.”

Seigniorage Algorithmic Stablecoins

Seigniorage algorithmic stablecoins refer to the difference between a coin and its production costs. Network participants are incentivized to maintain the value of a token by its minting and burning. Essentially, this system involves a token which is pegged to a stable value, and another token which is used to incentivize network participants to accurately rebalance the token pegged to the stable value. This is the stablecoin model which is implemented within the Terra Luna ecosystem for its stablecoins.

What is Terra Luna

Terra is a cryptocurrency project which was originally created nearly 4 years ago by Korean software company, Terraform Labs. Terraform Labs was founded by Daniel Shin and Do Kwon. The Terra project is designed to support a basket of stablecoins. What separates the Terra project from other similar cryptocurrency projects is that the Terra project is designed to operate as the backend protocol for the implementation of the cryptocurrency apps and products designed by Terraform Labs.

How Terra Works

The Terra mainnet was launched in 2019, and allows the creation of stablecoins, which are pegged to fiat currencies. The most common stablecoin created on the network is the UST token: UST is an algorithmically balanced stablecoin which represents the price of USD. UST is implemented in the same way that tokens such as USDT are utilized, however its value is not backed by the traditional 1:1 ratio of USD against each coin minted.

To mint UST on the Terra blockchain, the creator of the stablecoin needs to burn the equivalent amount of Terra’s native token LUNA. One of the most intriguing functions of Terra, is that the UST stablecoins created on its blockchain can respectively be burned by the network, in exchange for LUNA tokens. This ability to burn the network’s stablecoin – UST – in exchange for the native LUNA token is what stabilizes the UST tokens created on the Terra blockchain. The ability to burn the LUNA token at its current value, as well as burn the network’s UST stablecoins at their current value, incentivizes Terra Luna users to profit from each coin’s rebalancing. A user can potentially burn a Terra token, against the UST stablecoin on the network – or vice versa – to benefit from the difference in whichever token is inaccurately balanced. This ability to burn both UST stablecoins and LUNA utility tokens – in exchange for one another – stabilizes the supply and demand ratio of each.

The validators of the Terra network also provide Oracle services to confirm that the prices of both the LUNA token and the UST stablecoins are being rebalanced accurately. It is also important to mention that any discrepancies between the valuation of the LUNA token and the UST stablecoin are incredibly uncommon. This is due to the high number of network participants who are consistently arbitraging the value of both cryptocurrencies against one another.

One of the biggest factors behind the value of the LUNA token can be contributed to the fact that a small percentage of each LUNA token which is used for the minting of stablecoins, is not burned; rather, this small percentage of LUNA goes directly to the Terra community treasury. The holders of the LUNA token are responsible for determining how these tokens are spent. LUNA also acts as a governance token, in that its holders are also tasked with voting on the implementation of changes to the function of the Terra blockchain.

May 9th, 2022: The day Terra Luna Unraveled

On May 9th, 2022, the UST token dropped far below its $1 peg price. This led to even more downward pressure to the cryptocurrency market on a day which was already bleeding with red candles. The LUNA token simultaneously collapsed to nearly zero, leaving many investors confused, sad and angry. In many cases, the Terra Luna crash entirely wiped out the life savings of cryptocurrency investors that were particularly invested in the project. Terra Luna forums across the web were filled with sad posts.

How the Crash Happened

As of right now, there is no solid answer for what exactly caused the Terra Luna crash. Most of the information floating around is purely speculative and some of it leaning in the direction of conspiracy. What we do know however, is that the supply of the LUNA token spiked and its price subsequently plummeted. This caused the balancing mechanism that keeps the UST token attached to its peg of $1 to stop working. The dumping price of UST prompted panic selling which led to the minting of more LUNA tokens. This shot the circulating supply of the LUNA token from an average 345 million, to a whopping 6.5 trillion, within a matter of 4 days, hyperinflating the asset.

Is Luna’s Recovery Possible?

Terraform Labs CEO Do Kwon offered several recovery plans, however much of the crypto community is hesitant to believe that Luna’s recovery is possible after dumping over 99.9% of its value. Nonetheless, Do Kwon’s initial plan prioritizes absorbing the UST supply within the network. Do Kwon has also offered an alternative proposal which aims at recovering the layer 1 protocol by hard forking the Luna network.

As of the time of writing this article, Luna’s validators still haven’t come to a consensus on any plan to revitalize the project. UST is continuing to slide further away from its $1 peg, settling as low as $0.04.

Conclusion

The collapse of the Terra Luna project is undoubtably one of the most painful events in crypto, especially now, as it is still fresh in our minds, and with so many of us continuing to look for resolve and answers. This highlights why it’s so important to only invest with money you are willing to lose. It may seem tempting for new investors to place all their funds in one project that they believe to be the best, however cryptocurrency investing and indeed investing within all asset classes needs to be done with care, as none of us can truly see the future.

Diversifying your assets, and only adding funds to them when you have enough money to comfortably live is the hallmark of a good investor. A series of well thought out decisions now can little by little, lead you to a prosperous future later in life, while eliminating the risk of loosing everything if a project or asset somehow fails down the road. Learning as much as possible about the projects and assets you’re investing in, and seeking the guidance of professional traders as you navigate all that comes with making your money work for you is indispensable.

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