The LUNA Crash - Here's what happened

It wouldn’t be too much of an exaggeration to say that crypto markets are currently in freefall — and this tough month has been made worse with the disastrous crash of Luna, the primary cryptocurrency of the Terra blockchain, and the ecosystem built on it.

A stunning $40 billion in circulating supply has been wiped out, along with more than $80 billion in market value. This sent investors into a selling frenzy, triggering a vicious bank run that would ultimately result in the crypto market’s capitalization losing more than $400 billion altogether.

So, what has caused the biggest demise of a stablecoin with such a large market capitalization? What actually happened, and why is LUNA unlikely to recover? We’ll answer all of those questions in-depth below.

Before we can delve into more details on what caused the LUNA crash, we should briefly explain what it actually is.

So, the events of this month were largely driven by the downfall of two native tokens on the Terra blockchain — Terra USD (UST) and Terra Luna (LUNA). Unlike the LUNA, UST was a stablecoin pegged to USD at a 1:1 exchange rate.

Normally, stablecoins are, as the name suggests, more stable — a safe haven for crypto investors in periods of choppiness on the DeFi markets. When necessary, crypto traders would normally convert volatile assets into stablecoins, rather than trading them for hard cash — that would be far more expensive and have certain tax implications.

But why has Terra UST failed in its basic function as a stablecoin?

Well, not every stablecoin derives its value in the same way — some are backed by reserves set up by foundations, ensuring that all investors could potentially be paid out if they wanted to sell for any reason.

However, the UST was an algorithmic stablecoin — which means it was pegged to USD by a combination of code, market activity, and an algorithmic link to the base currency of the Terra blockchain: Luna. In practice, this system allows you to get a single unit of UST in exchange for “burning”  $1 of Luna — or vice versa.

Hand-in-hand, UST and LUNA experienced tremendous and unprecedented growth in the past few months, both in terms of adoption and market share. The growth was largely the result of growing demand for UST — which happened for a very specific reason.

There are a couple of UST use cases on the Terra blockchain, but one has eclipsed all others in the previous six months: the Anchor protocol.

This lending and borrowing protocol promised an unprecedented 20% yield to crypto traders who would buy UST and add it to the platform’s liquidity pool. As a result, the Terra ecosystem experienced a huge TVL (total value locked) growth — from a (more realistic) $0.5 billion to as high as $18 billion before the mid-May crash. While this has definitely fueled wider adoption of the Terra blockchain, the process happened primarily due to the Anchor offer.

Consequently, LUNA also became one of the stars of the crypto market — being one of the few crypto assets that actually saw its value appreciate in 2022.

Unfortunately, the critics who pointed out that UST lending on Anchor couldn’t really give an APR of 20% to all investors were ultimately right — the mathematics simply didn’t add up. Terra developers noted as much themselves, but only while comparing this advertised rate as a form of raising awareness rather than a concrete promise to investors.

This bubble started bursting on May 7th, when a large $85 million UST-for-USDC swap was made on Curve, the biggest exchange liquidity pool for UST. That trade seems to have triggered an avalanche of swaps, and the initial 2% discount and de-pegging.

While UST actually did rebound, it hadn’t managed to recover the peg. At that point, fear among crypto traders and investors had already spread wide enough — in less than a single day, $2 billion of UST was sold off.

Certain blockchain experts believe that the initial $85 million trade was an orchestrated maneuver by some wealthy investors who had borrowed BTC to buy (and subsequently, short-sell) UST.

Regardless of whether this was an intentional attack or not, the bank run that ensued was unstoppable. Investors who were trying to earn interest through Anchor all ran for the door and dropped UST before it was too late. And seeing as the currency was linked to LUNA, it also entered an identical death spiral. After being worth over $115 in April, LUNA is now worth less than a penny.

Plenty of investors who gambled their life savings on Luna and Terra saw their funds evaporate in just a few days. And the LUNA crash took down the wider crypto market as well — which was already declining even before the Terra crash, as a result of higher Fed interest rates.

The LUNA crash kicked the crypto market while it was down, primarily because Do Kwon, creator of Terra, had billions in BTC as a reserve for UST. Once the death spiral was imminent, his Luna Foundation deployed over $3 billion in an attempt to save the peg.

However, when the attempt failed, it put even more downward pressure on the crypto market — plenty of large investors started selling off their own BTC shares. The last-ditch effort to save UST failed, and Bitcoin dropped to its lowest rate since December 2020.

While algorithmic stablecoins get considerable upward force in a bull market phase, their initial popularity becomes their undoing during a bear market — that force works in reverse in the case of a bear market.

The resulting crash created a ripple effect throughout the entire global crypto ecosystem, which is understandably sensitive to BTC drops and the demise of a stablecoin. Ether ended up plunging under $2,000 because around $30,000 of Ether was also sold in a separate attempt to stabilize UST’s peg.

And Ethereum’s already notorious transaction fees spiked, as huge numbers of investors started dropping their Ethereum-based stablecoins after the demise of UST, which was perceived as a reliable stablecoin.

Coinbase, the largest crypto company listed on the NASDAQ, also plummeted by 35% in the following week. A combination of all of these events also resulted in a plunge in the NFT ecosystem, whose sales volume was reduced by a stunning 50%.

The end result was hundreds of billions of dollars being lost across the crypto ecosystem. However, while a certain period of lower interest for crypto among mainstream investors will likely follow, the long “crypto winter” some have predicted after Terra’s crash is likely an overreaction. Even by conservative estimates on Bloomberg, the slowdown of capital investment in the crypto space will last for mere months.

At this point, it’s almost a certainty that LUNA won’t recover from its crash, which has triggered lower trust in stablecoins in general, let alone UST and LUNA specifically.

However, there are a few crucial lessons to be learned by examining the events that have unfolded.

First of all, exploring the mechanisms that keep stablecoins pegged is more important than ever before — especially considering the constant appearance of new derivative DeFi products, like liquid staking and bridged assets.

As with any other kind of investment, understanding the risks and the rewards in equal measure is vital to long-term success. And the rewards are gladly advertised on any DEX platform that wants to raise its liquidity pools — high APRs, which are simply impossible in many cases; at least for all investors.

However, the accompanying risks are much harder to quantify. Many investors in more traditional assets are quick to label these DeFi systems as “Ponzi schemes” — a description that severely undervalues the innovation that’s driven by liquidity pools and the democratization of global finances.

These overblown incentives are ultimately marketing tools for giving these systems enough juice to make them actually self-sustaining — but that also brings a certain level of fragility that should always be at the back of investors’ minds.

DeFi protocols generally involve large numbers of market participants who interact in real-time — which, while beneficial in a bull market, means that panic and fear also spread much faster in a bear market like the one we’ve experienced in 2022.

Historically, de-pegging events usually happened after a liquidity mismatch — where there was less liquidity than necessary to theoretically pay out all investors if they wanted out simultaneously. This liquidity mismatch is, in itself, a self-fulfilling prophecy that’s generated by fundamental mistrust in the underlying system.

As a result, it’s important to analyze different “rush to the exit” scenarios and try to model situations in which the system could actually revert to a balance necessary to stabilize the peg and the necessary circumstances for that turn of events.

Also, stablecoins will likely draw more attention from regulators in the future. Congress has already set its sights on this type of cryptocurrency after last December’s hearing which explored stablecoins’ benefits and risks. The President’s working group on financial markets has already called for regulatory action on them, though with no further concrete actions.

LUNA’s crash will likely provide overzealous regulators with more ammo, under the flag of preventing similar disastrous crashes in the future and mitigating risk.

However, there are plenty of regulators who also believe that stablecoins will play an essential role in maintaining the crucial role of the U.S. dollar as the reserve currency of the world — so even with greater regulation, stablecoins will likely continue to play a crucial part in the financial markets of the future.