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Terra’s Downfall ⤵️

Last week, Crypto markets crashed, with major coins like BTC and ETH losing near 30%. Overall, more than $200 billion was erased from the entire crypto market. On Friday of last week, the market began to slowly make its first steps in recovery, with Bitcoin returning to a $30,000 price level. Despite all of this, the event’s long-term effects are there to stay, including the disheartenment of many investors and contributors in the web3 and DeFi community. So why did all this happen? Well, it wasn’t an external cause like a new war, virus, or something else we’re used to seeing, but the effect of a project within DeFi collapsing. The details are somewhat esoteric if you’re not familiar with DeFi, however, we will do our best to break it down.

This is what essentially happened. A company called Terraform Labs, which maintains the open source blockchain called Terra, completely collapsed. Terra creates stable coins designed to consistently track the price of a fiat currency. In this event, Terra’s algorithmic stable coin pegged to the dollar called “UST,” collapsed. There are many kinds of stable coins, but UST is a kind of “algorithmic stable coin,” meaning, it is not backed by any reserves, but rather, by an algorithm coded to strike a balance between the Stablecoin and a partner coin. In this case, UST is the stable coin, and its “partner coin” is called Luna. Luna is also used for Terra’s blockchain governance and mining. The way 1 UST maintains its value of $1 is through a semi-automated algorithm that will “mint” or “burn” more of the other as needed. When Luna is in excess, it will be burned to mint UST, and vice versa. Through this mechanism, Terra’s UST maintains its peg to the dollar. The crash occurred because, last week, over $2 billion worth of UST was unstacked for an unknown cause — pushing Terra to $0.90. This caused investors to burn their UST for Luna — a simple arbitrage opportunity. Unfortunately, there was a rule stipulating that only $100 million worth of UST can be burned for Luna per day. This limit choked the stabilizing process and lead investors to sell their Terra once it was clear it couldn’t retain its peg — causing Luna to fall from $116 to just a penny and UST to fall to as low as 30 cents. What do you think about this historic crypto crash? And did this explanation make any sense?

I am not a financial advisor and my comments should never be taken as financial advice. Investments come with risk, so always do your research and analysis beforehand.

Originally published at https://invstr.com on May 16, 2022.

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