Luna Cryptocurrency Collapse: How UST Broke and Why It Matters

The cryptocurrency market isn't pretty right now. Look anywhere and you'll see red: bitcoin and ether are both down over 30% week-over-week, hitting lows not seen since 2020, and altcoins like solana, dogecoin and cardano are faring even worse. 

It's bad news for crypto investors, but nothing unheard of. These are notoriously volatile assets reacting to tempestuous economic conditions. 

What's much more unusual, and much more important, is the collapse of the luna cryptocurrency and its associated TerraUSD (UST) stablecoin. 

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 has 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 one US dollar at all times, but depegged on Saturday and has since fallen to as low as 30 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. Its marketcap now stands at $641 million, down from a peak of over $40 billion. 

"This is historic for the crypto markets," said Mike Boroughs, cofounder 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 US dollars. 

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

Say ether's price is $1,900 (where it is today), a trader could exchange one ether for 1,900 USDC tokens. If tomorrow ether drops 50% to $950, those 1,900 USDC tokens could be exchanged for two ether, since the USDT is designed to retain its $1,900 value. 

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

The Terra UST coin is different to Tether and USDC in a key way. Tether and USDC are backed by actual US dollars, whereas UST is what's known as an "algorithmic" or "decentralized" stablecoin. 

The idea is that, through a few clever mechanisms, plus about $1 billion of bitcoin reserves, the UST's dollar peg can be maintained without it having to be backed by actual US dollars. 

"A decentralized stablecoin is the Holy Grail of DeFi," explained Cyrus Younessi, former Head of Risk Management at MakerDAO, the group behind DAI stablecoin. 

Bitcoin and ether's selling point 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 Saturday, over 70% of UST's circulating supply, around $14 billion, was deposited in this scheme. 

Here's the key to UST retaining its peg: 1 UST can always be exchanged for $1 worth of luna. So if UST slips to 99 cents, traders could profit by buying a huge amount of UST and exchanging it for luna, profiting one cent per token. 

The effect works in two ways: People buying UST drives the price up, and UST being burned during its exchange to luna deflates the supply.

Then there's the reserves. Terra founder Do Kwon created the Luna Foundation Guard (LFG), a consortium whose job it was to protect the peg. 

The LFG had about $1.5 billion in bitcoin reserves: If UST dipped below $1, bitcoin reserves would be sold and UST bought with the proceeds. If UST goes above $1, creators would sell UST until it goes back to $1, with the profit being used to buy more bitcoin to pad out the reserves. 

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