The sudden drops in TerraUSD, a stablecoin, and Terra Luna, its sister currency have caused a major shakeup in the cryptocurrency market. The market has been shaken by the crash, as other tokens such as bitcoin and tether also have struggled. Terra Luna is almost worthless. Bitcoin dropped 25% in that week.
The recent plunge in the crypto market demonstrates the risks associated with a new financial system that has been largely unregulated. What actually happened? What will this mean for the rest of the crypto ecosystem? What is Terra and why does it have Luna as a sister currency? Here are some facts.
What is the stablecoin exactly?
Stablecoins are cryptocurrencies that can be tied to other assets, such as the US dollar or euro. These cryptocurrencies are less volatile than other cryptocurrencies like bitcoin and ether that can swing wildly throughout the day.
Stablecoins act as a link to traditional financial systems, and as such is a currency that is easily understood by many. Stablecoins are a great option for investors who want to protect their capital while remaining within the cryptocurrency ecosystem.
Tether, which is the most popular stablecoin, and USD Coin, which were both created in conjunction with Coinbase Global, are two examples of some of the most well-known stablecoins. A stablecoin that is USD-fixed should theoretically maintain $1 per token. However, this has not been the case.
TerraUSD (UST), and Terra Luna Explained
Some stablecoins like tether are supposed to have assets backing them, but others rely on complicated algorithms to keep their peg to US dollars.
TerraUSD is an algorithmic stablecoin. It attempts to maintain the same US dollar value by using complex seesawing mechanisms with a related cryptocurrency called Terra Luna (or simply Luna). Although 1 TerraUSD (UST), is supposed to be exactly $1, Luna’s value can fluctuate. TerraUSD uses Luna to keep its dollar peg in place. Here’s how it works.
To mint or create Luna, you can either destroy or burn TerraUSD, or vice versa. One TerraUSD equals $1 worth Luna. One TerraUSD equals one TerraUSD. It’s like a sawsaw. TerraUSD is at one end and Luna at the other.
Let’s say that TerraUSD is worth $0.99. Smart people will take advantage of the opportunity to purchase $1 TerraUSD worth of Luna for 99 cents and make a small profit of 1%. They burn their TerraUSD and mint Luna to make a profit.
TerraUSD is becoming more scarce as more TerraUSD holders try to make Luna 1 cent profit by burning it. As a result, its supply decreases and its value rises until it reaches its $1 peg.
Imagine that 1 TerraUSD is now worth $1.01 because so many people are using the arbitrage. This means that those who hold Luna know that they can burn $1 worth of Luna to get TerraUSD, making an additional cent. As more people use their Luna to make TerraUSD, TerraUSD’s supply increases and TerraUSD’s price drops until it reaches $1.
Let’s face it, if you don’t understand the mechanism we have just described, then you shouldn’t be investing in stablecoins.
What happened to TerraUSD and Terra Luna Recently?
The simple answer: The balancing act between TerraUSD & Luna failed.
Anchor Protocol was the main reason most people owned TerraUSD. Anchor is like a savings account for TerraUSD. However, it pays 20% interest which is really great for a savings bank.
It was easy to park TerraUSD in Anchor and see the 20% yield. This is especially true since you don’t have many cryptocurrencies that you can use. The anchor was the last place 75% of TerraUSD circulated up to Saturday.
Anchor adopted a resolution in March to replace the 20% rate with a variable rate. According to the Wall Street Journal, large amounts of TerraUSD were taken from Anchor over the weekend. This worried traders who had to sell their TerraUSD tokens and Luna tokens. Curve Finance, a blockchain-based project, was used by another group of investors to exchange TerraUSD for stablecoins.
People began to seek the exits by exchanging TerraUSD for Luna. Luna’s supply exploded, and the price plummeted. Luna was in a sense pushed off the sands.
The balancing mechanism became inoperable as more people attempted to dump their TerraUSD. Luna also crashed with it. At one point, the stablecoin dropped to $0.14 on 5/13. Luna is almost worthless. It also tanked to less than 0.01 cents on 5/14.
Investors in crypto are closely watching the regulatory actions of regulators, especially “if there will be some kind of collateralization requirement that will get imposed upon all projects that wish to offer stablecoins.”