Terra Luna — Crisis Explained

4 min read
Terra Luna Crisis Explained

Learn about the Terra’s ecosystem which was targeted in what appeared to be a coordinated attack.

On May 7, Terra’s ecosystem was targeted in what appeared to be a coordinated attack, resulting in one of the biggest drops in cryptocurrency prices since the financial crisis of 2008, wiping out billions of dollars in long positions on major exchanges.

For most of the week, the Terra-backed UST stablecoin caused problems with the Terra blockchain, which relies on the LUNA token to power it. As a result, there has been an unprecedented loss of wealth in stock, and cryptocurrency markets globally.

UST, which is programmed to keep its dollar peg at $1, is currently trading at $0.1718 as of this time of writing, having lost its dollar peg and putting LUNA and itself in a death spiral. The loss of faith from the community and aggressive panic selling prompted the price of LUNA to drop 99.9% and is currently trading at $0.0002347. After trading at an all-time high of $119 USD in recent months, the crypto native token has seen its value plummet by more than $41 billion.

Let us decipher the relationship between UST and LUNA and understand this catastrophic crypto market event:#

The Terra ecosystem uses LUNA tokens for the staking and mining of UST. The equivalent amount of UST is minted each time LUNA is burned. UST is an algorithmic stablecoin, which means that its value is tied to the underlying LUNA, rather than to real-world financial assets such as the USD. This means that LUNA tokens serve as collateral for UST and are responsible for UST’s long-term viability and stability.

UST aims to maintain equilibrium by minting and burning at a 1:1 ratio with LUNA. To put it simply, a user must burn an equal amount of LUNA in order to mint the equivalent amount of UST.

Although this increases capital efficiency, it makes UST’s survival entirely dependent on LUNA’s market demand. In the event that the market loses faith in them and starts trading large quantities of UST for LUNA, then both LUNA and UST are at risk of a death spiral attack.

Depegging of UST#

A series of multi-million dollar sales hampered the depegging of UST. To put it into perspective, On May 7th, a Curve pool experienced an $85 million swap from UST to USDC, which caused the pool’s liquidity providers to begin withdrawing their assets. UST’s peg was slightly lowered after a user sold $108 million worth of tokens on Binance, according to another on-chain data source.

Luna Foundation Guard (LFG) responded by deploying $1.5 billion of its reserves on May 8. There have been reports that they lent $750 million of BTC to market makers to be sold, and another $750 million of UST to purchase back BTC once the volatility had calmed.

A total of $2.86 billion had already been taken from the Terra lending protocol Anchor, which offered depositors in the U.S. a treasury yield of up to 20 percent. UST’s peg continued to collapse the following day, with its price on Binance dropping to $0.60.

By minting LUNA for UST, users could exit as more liquidity providers exited with what they had left. As a result, the LUNA supply went from 386 million to 32 billion in less than 48 hours, igniting the death spiral. LUNA’s price fell to $0.01 while UST’s plummeted to $0.225 on Binance.

This left the Terra network exposed to governance attacks, in which the majority of attackers might hypothetically collaborate to take control of the remaining assets while the network’s liquidity and staking reserves were at their lowest point. To avoid such scenarios in light of the recent dip in the value of the $LUNA token and the consequently lower attack costs, Terraform Labs, the company behind the Terra network, temporarily suspended the blockchain on May 12.

The arbitrage opportunity for users to burn UST and mint LUNA exists as long as the price of UST is below its peg. As a result, until the UST value is restored to its $1 peg, this arbitrage opportunity will continue to exist, creating a loop in which LUNA can always be obtained at a much discounted rate.

Many retail traders and financial institutions’ investments in LUNA and UST have lost a significant amount of their original value as a result of this. KSI, a YouTuber and Gogglebox star, with 157,000 Luna in his account, lost £2.8 million in a day, with his assets worth dropping over 99 percent, almost equal to $1000 on May 13.

In light of the UST-LUNA crisis, many analysts and crypto enthusiasts now expect the current bearish sentiment to deepen and last for a very long winter.