The hottest topic in the crypto market is Terra, code name LUNA. Since around May 10, LUNA has fallen sharply and is now close to zero. The algorithmic stablecoin TerraUSD, code name UST, recently lost its peg to the US dollar and came under heavy selling pressure. The pressure has not eased, and its market value has fallen 99% from USD 18 billion to near zero.
WavingCat invited Ryan, a blockchain and cryptocurrency technology application development expert, to analyze the reasons behind LUNA’s collapse from a professional perspective.
Terra creator Do Kwon and the team made a final effort by increasing the daily minting speed of new LUNA, hoping to use the original LUNA/UST mechanism to restore UST to around USD 1. Unfortunately, the result went the other way. For the Terra ecosystem, even sacrificing LUNA could not save UST, and all reserves could also be lost. The scale of this crypto-market shock triggered by the UST de-peg was far larger than expected. To analyze what may happen next, we first need to understand algorithmic stablecoins.
What Is LUNA?
Founded by South Korea’s Terraform Labs in 2018, Terra is a cryptocurrency ecosystem that provides stablecoins pegged to fiat currencies and cross-border payment functions. It can be understood as a cross-border e-commerce platform in the blockchain world.
Terra uses a dual-token system, the well-known LUNA and UST. UST is an algorithmic stablecoin. An algorithm is a defined computer formula executed automatically. UST uses LUNA as leverage without collateral, relying on the algorithm to maintain a 1:1 peg with the US dollar and automatically adjust stablecoin supply to stabilize price.
Why LUNA Collapsed
Terra’s algorithm mainly uses continuous trading between LUNA and UST to maintain value. When UST falls below USD 1, the LUNA foundation is affected and begins selling LUNA to buy UST and maintain stability. In other words, it mints LUNA and burns UST to push up the UST price. When market supply falls, price should rise.
Conversely, when UST is above USD 1, Terra can burn LUNA and mint UST, bringing the price back to USD 1.
However, when selling pressure continues to increase faster than the system can respond, a death spiral can occur. More holders sell LUNA, causing LUNA’s value to fall. It then becomes harder to buy enough UST to stabilize the price. To maintain the peg, even more LUNA must be sold. The final result is the sharp collapse of both LUNA and UST to near zero.
Experts in the crypto community had already raised the possibility of a LUNA/UST death spiral in 2021. Founder Do Kwon created the non-profit Luna Foundation Guard (LFG), hoping to raise a USD 4 billion Bitcoin reserve pool to support UST and prevent such a spiral. Unfortunately, before the full reserve was raised, the death spiral had already occurred. LFG lent out its entire 37,000 Bitcoin reserve during the incident, and the reserve was exhausted. According to the latest official announcement at the time, the Terra blockchain and deposit and withdrawal services were suspended.
The core problem of algorithmic stablecoins is that one cryptocurrency is used as the backing for another cryptocurrency, without being linked to real-world assets. If public confidence drops and many holders redeem at the same time, an entire cryptocurrency ecosystem can face collapse.
Stablecoins also have different categories. Apart from algorithmic stablecoins, there are fiat-backed stablecoins and commodity-backed stablecoins. The latter two are linked to or collateralized by fiat currency or commodities, making their prices relatively more stable than algorithmic stablecoins backed by another cryptocurrency.
As supporters of blockchain technology, it is regrettable to see LUNA/UST and the Terra blockchain fail and approach collapse. UST was one of the most successful algorithmic stablecoins apart from collateralized stablecoins such as USDT and USDC, and Terra was a new-generation blockchain with strong developers and community support. It may now fade from the blockchain trend following the failure of LUNA/UST.
Technology and financial innovation always come with high risk and high reward. How will the blockchain and cryptocurrency market change after LUNA/UST? When promoting technology innovation and blockchain applications, how should major loss risks be avoided? Will the LUNA/UST incident lead governments to introduce strict regulations that may hinder blockchain innovation in the name of stability?
Although blockchain remains uncertain, this year’s blockchain and DeFi market is still full of innovation opportunities. Every major incident pushes blockchain and cryptocurrency technologies and applications toward greater maturity. Are you ready for the next larger wave?
This article is based on personal experience and online information. It is not investment advice.
Ryan Ip
Blockchain and cryptocurrency technology application development expert
Co-founder of NineBlocks
Ryan entered the IT and innovation industry in the 2000s, working first at a well-known systems integration company, then in mobile game design and development, and in recent years fully committing to blockchain. Ryan currently leads a Hong Kong-based development team of more than 50 people, providing blockchain technology advice, smart contract development and DeFi and GameFi project planning for listed companies and financial enterprises. With more than 20 years of experience, he uses a senior IT perspective and accessible language to explain the technical principles behind blockchain business applications and the crypto market.
Translation supported by AI.