Luna Crypto Crash: How UST Broke, Why It Matters and What's Next

The cryptocurrency market isn't pretty right now. Red is everywhere: Bitcoin and ether are at their lowest points since 2020, and altcoins like dogecoin and cardano are faring even worse. 

While it's painful for crypto investors, this dip is far from unprecedented. Cryptocurrencies are infamous for their volatility, and tempestuous economic conditions are bringing down not just crypto, but the stock market too.

What is unprecedented, however, is the collapse of the luna cryptocurrency and its associated terraUSD stablecoin, aka UST. 

You may not have heard of UST before, or know what a stablecoin is, but it's a big deal. Billions of dollars in crypto wealth have been vaporized, sending shockwaves throughout the whole market. 

There are two intertwined stories here: That of the UST stablecoin and that of luna, both of which are part of the terra blockchain. 

The UST coin is designed to retain a value of $1 at all times, but it was depegged last Monday, on May 9, and has since fallen to just 17 cents. 

Then there's luna, the centerpiece of terra's ecosystem. Its value has collapsed in one of the most stunning crypto crashes ever recorded. 

The coin's price fell from $116 in April to just a penny on Thursday. It's fallen further, trading over the weekend for a fraction of a cent. 

At the time of writing, luna is down to an eighth of a penny. Such an implosion has been seen for small-cap memecoins in the past, but never for something the size of luna, which had a market cap of over $40 billion just last month. 

"This is historic for the crypto markets," said Mike Boroughs, co-founder of crypto investments firm Fortis Digital. 

"This is a defining moment for the space due to its size and impact in terms of the amount of people that lost substantial value."

To understand the crypto catastrophe, you first need to know what a stablecoin is. In essence, it's a cryptocurrency that's pegged to a more stable currency. 

The biggest such coins are tether and USDC, which like most stablecoins are both tied to the US dollar. So if you have 1,000 USDC tokens, for instance, they can at any time be exchanged for $1,000. 

Stablecoins are integral parts of "DeFi," or decentralized finance, designed to be ways for investors to hedge against the volatility of the cryptocurrency market. 

Say ether's price is $2,000 -- a trader could exchange one ether for 2,000 USDC tokens. If tomorrow ether drops 50% to $1,000, those 2,000 USDC tokens would still be worth $2,000 and could be traded for two ether tokens. 

When investors smell a downswing coming, they put their money on stablecoins like tether, USDC and, until this week, UST.

Stablecoins also provide the means for cryptocurrency loaning and borrowing, making them a foundational technology of DeFi. 

The terra/UST coin is different from tether and USDC in a key way -- it's not backed by actual US dollars, but rather is what's known as an algorithmic or decentralized stablecoin. 

The idea is that, through a few clever mechanisms, plus billions in bitcoin reserves, the UST's dollar peg can be maintained without it having to be backed by the dollar. 

"A decentralized stablecoin is the Holy Grail of DeFi," said Cyrus Younessi, former head of risk management at MakerDAO, the group behind DAI stablecoin. 

The selling point of bitcoin and ether is that they're difficult for bureaucrats, politicians and central bankers to control, but their downside is price volatility. "If you could take those assets, extract stability out of them and productize it, then that's huge," Younessi said.

Terra is a blockchain, just like ethereum and bitcoin. While ethereum's blockchain natively produces ether tokens, terra natively produces luna. Before the depeg, luna was trading at $85.

To create UST, you need to burn luna. So for instance, last week you could trade one luna token for 85 UST (since luna was worth $85), but the luna would be destroyed ("burned") in the process. 

This deflationary protocol was meant to ensure luna's long-term growth. As more people buy into UST, more luna would be burned, making the remaining luna supply more valuable. 

To entice traders to burn luna to create UST, creators offered an insane 19.5% yield on staking -- which is essentially crypto terminology for earning 19.5% interest on a loan -- through what they called the Anchor Protocol. 

Instead of parking your savings at a bank for a 0.06% interest rate, the pitch is to turn put your money into UST, where it can earn nearly 20% in interest. 

Before the depegging, over 70% of UST's circulating supply, around $14 billion, was deposited in this scheme. 

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