The recent Terra (LUNA) and TerraUSD (UST) crypto crash has sent shockwaves throughout the blockchain industry. After being widely used throughout 2021, the project is now under fire after the tumbling prices of both crypto assets. The UST token has been well below its price peg of $1.00 since the LUNA token crash began to unfold on May 7th, 2022. As investors scramble to make sense of the situation and repair the damages, many are left wondering, "what happened to LUNA?". Read on as we unpick the LUNA crash and explore the impact it could have on the blockchain industry.
In this article, we're going to dive deep into the Terra LUNA and UST crypto crash. We will provide an overview of the decentralized algorithmic stablecoin protocol and discuss the events leading up to the infamous LUNA crash. Also, we'll explore the possible knock-on effects and how the crash may impact the blockchain industry. Furthermore, we'll consider the future of algorithmic stablecoins and answer common questions such as, "what is the LUNA token?", "what happened to LUNA?", and "how does UST work?".
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What is Terra?
Before we address the question of "what happened to LUNA?", let's first take a look at the project behind UST and LUNA. Terra is a Cosmos-based smart contract-enabled public blockchain network. It is home to a suite of multi-collateralized, algorithmic stablecoin protocols and cross-chain dapps (decentralized applications). The project aims to promote the adoption of decentralized technologies by making it simple for businesses to accept and automate crypto payments without intermediaries. Terra uses a dual token model that incentivizes arbitrage opportunities and encourages platform adoption. Stablecoins such as TerraUSD (UST) maintains their price pegs through the native LUNA token.
Furthermore, Terra has a thriving development community. The platform has gained significant adoption throughout 2022. It is home to a series of prominent DeFi (decentralized finance) protocols, including Mirror Protocol and Anchor Protocol. This popularity has created high demand for the LUNA token and drawn substantial traffic to the TerraUSD (UST) stablecoin protocol.
The Terra network was built using the Cosmos SDK (software development kit). It also uses the Cosmos-native tendermint proof-of-stake (PoS) consensus mechanism and can accommodate a maximum of 100 validators. This number makes the Terra blockchain network more centralized than many competing PoS chains. However, transactions on the Terra network take seconds to finalize. Furthermore, interacting with smart contracts and DeFi protocols on Terra is significantly less expensive than interacting with similar protocols on Ethereum.
Background
Created by Korean blockchain firm Terraform Labs and incubated by Terra Alliance, the Terra blockchain was established in 2018 by Daniel Shin and Do Kwon. Terra Alliance comprises 15 e-commerce firms headquartered in East Asia. The Terra mainnet went live in April 2019. The first asset to be introduced to the network was the TerraKRW (KRT) token. KRT is a stablecoin pegged to the Korean won. However, the initial LUNA token private sale raised around $32 million from several high-profile investors, including Binance, OKEx, and Houbi. Furthermore, the offshoot organization, "Luna Foundation Guard" (LFG), has gone on to raise more than $1 billion from six investors to purchase Bitcoin (BTC) as a reserve asset.
What is the LUNA Token?
The Terra LUNA token is the primary unit of account at the heart of the Terra ecosystem. It is essential for maintaining the price peg of stablecoins built on Terra. Plus, it enables holders to vote on governance proposals to make changes to various parameters of the platform. Also, burning the LUNA token stabilizes the Terra stablecoin network and incentivizes platform adoption using arbitrage opportunities.
The maximum supply of LUNA tokens is one billion. If the supply exceeds this number, the protocol burns LUNA tokens until it reaches this target supply. Burning $1 of LUNA enables participants to mint $1 of TerraUSD (UST). To achieve this, users must interact with a smart contract that uses a price feed from an oracle to determine the exchange rate between LUNA and UST.
The LUNA token is also essential for paying transaction fees throughout the Terra network. Plus, holders can stake LUNA to participate in the delegated proof-of-stake (DPoS) consensus mechanism and earn a portion of network fees.
What is the UST Token?
TerraUSD (UST) is an algorithmic stablecoin with a price target of one US dollar. It relies on the burning of LUNA to keep this price peg rather than collateral. Burning LUNA helps to reduce the token supply, making the asset scarce. Also, when the price of the UST token is lower than a dollar, it creates an arbitrage opportunity to buy it at a reduced price. On the other hand, when the price of one UST token is higher than a dollar, LUNA holders have an incentive to sell their LUNA tokens for UST.
The value of the UST token is established via supply and demand. As the supply of UST expands, the market cap shrinks until UST achieves its price target of one dollar. Furthermore, UST supply increases have historical correlations with the positive price action of the LUNA token. Accordingly, the price of the LUNA token often reflects increases in the adoption of the Terra ecosystem.
What Happened to LUNA? Unpicking the UST and LUNA Crash
So, what happened to LUNA? The chain of events that eventually led to the monumental LUNA crash and de-pegging of the UST stablecoin began on the decentralized exchange (DEX) from Curve Finance. Curve Finance is a highly liquid exchange that makes it easy to swap stablecoins with minimal slippage. On May 5th, 2022, the "UST-3pool" liquidity pool, which consisted of equal parts UST token and TriCrypto (USDT/USDC/DAI), began to increase in UST token dominance. As more investors began to exchange UST for more trusted stablecoins, the price of UST briefly fell to $0.986 on the Binance exchange. However, it would take almost 24 hours for anyone to report the issue.
Despite the brief recovery to $0.98 a few hours later, investor confidence was inevitably shaken. When this took place, the "UST-3pool" Curve pool held more than $1.23 billion. Also, the Terra Foundation and Curve Foundation were testing a new stablecoin pool called "4pool". This pool was to contain four stablecoins: UST, FRAX, USDC, and USDT. Both FRAX and UST are algorithmic stablecoins, while USDT and USDC were fiat-collateralized. Furthermore, 4pool was designed to generate a steady yield on stablecoins and attract substantial liquidity.
Testing began for 4pool on May 4th, 2022, on Fantom and Arbitrum ahead of deployment on the Ethereum mainnet. Unfortunately, 4pool didn't make it onto Ethereum. The exodus of non-UST stablecoins from UST-3pool resulted in the pool losing around $560 million of non-UST stablecoins in three days. In addition, non-UST stablecoins became highly illiquid during this period, making it difficult for UST holders to swap their assets for other stablecoins.
What Happened to LUNA? - The Cascade
With the dwindling price peg rocking investor confidence and the exodus of liquidity from UST-3pool, things quickly went from bad to worse. The highly liquid Binance UST/USDT trading pair began to expedite the de-pegging of UST. In just thirteen hours, the UST price fell to $0.59, falling to $0.22 just two days later.
With the correlation between LUNA and UST, the price of LUNA fell as well. As a result, the cascade of liquidations still echoes throughout the crypto markets. At the time of writing, the LUNA token is trading at around $0.013404, down almost 100% from the all-time high of $119.18 on April 5th, 2022. Furthermore, the UST token is trading at $0.496, according to CoinGecko.
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Luna Foundation Guard (LFG)
Luna Foundation Guard (LFG) is a Singapore-based nonprofit organization that aims to support the expansion of the Terra ecosystem. This includes providing grants for emerging projects throughout the Terra ecosystem. LFG raised $1 billion in a record funding round through the sale of LUNA tokens.
These funds intend to help create a Bitcoin-denominated reserve for UST and strengthen the peg of UST in the coming years. This involves moving away from relying purely on market dynamics to retain the price peg of the UST token. A basket of crypto assets backs the LUNA reserves. Furthermore, many of these assets are experiencing the knock-on effects of the crash amid a market-wide downturn.
What Does This Mean for the Blockchain Industry?
The LUNA crash raises questions about the reliability of algorithmic stablecoins. Other projects that adopt a similar model are coming under increasing scrutiny as calls for regulation and collateralization threaten to derail the algorithmic stablecoin movement. US Treasury Secretary Janet Yellen is calling for tighter regulations on stablecoins as the LUNA crash is just the latest in a string of failures by algorithmic stablecoins.
The fallout of the LUNA crash is having a ripple effect on other crypto assets. Assets that form part of the LUNA reserves also feel the impact of the LUNA crash. In addition, increasing pressure from regulators prompts investors to think twice about which crypto assets they hold. Furthermore, the UST and LUNA crash impacts anyone holding stablecoins. Almost every major stablecoin is experiencing price peg deviations. Many new investors are mistaking the UST token for the popular USDT stablecoin, causing large sell volumes on multiple crypto exchanges. Plus, cascading liquidations on Curve Finance are causing an uproar throughout the DeFi community.
While the recent LUNA crash outlines the need for tighter regulation, it may encourage DeFi innovators to think about the long-term implications of these next-generation technologies. In the future, we may see more DeFi projects considering the sustainability of the technologies they create to avoid further instances of this event occurring in the future.
What Happened to LUNA? The UST and LUNA Token Crash Explained - Summary
Despite the various failings and misfortunes of the project, LUNA token burning and selling continued in an attempt to maintain the UST token price peg until validators halted operations earlier today. In a tweet, Terra co-founder Do Kwon stated that he plans to introduce "several remedial measures" to help restore the project and the faith lost by the community. To facilitate this, the Terra team will increase the amount of UST they can mint from the base pool, effectively attempting to print their way out of the situation. However, we will have to wait and see how this pans out.
That said, faith in algorithmic stablecoins is currently at an all-time low. Mounting pressure for stablecoin projects to disclose transparent reserves suggests that algorithmic stablecoins could become too risky for long-term investors. Moreover, regulators will likely come down hard on future DeFi innovations to prevent this type of event from occurring in the future.
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