The crash of Terra and Luna: the death spiral of cryptocurrencies

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El desplome de Terra y Luna: la espiral de la muerte de las criptomonedas

On Monday of this week we told you how the Bitcoin cryptocurrency plummeted below the $33,000 mark, a minimum it had not reached since July 2021. The best-known cryptocurrency reached a record value of almost $69,000 in November 2021. But in just 4 months, its price has fallen by 50%. And it didn’t stop, but Bitcoin dipped even further, dipping below $25,500 no less last Thursday.

StableCoin

Digital currency or digital money on the Internet is a means of exchange other than real money that has properties similar to physical currencies and allows instant transactions and transfer of property without borders. Digital currencies like bitcoin are known as “decentralized digital currencies”which means that there is no central point that controls the money supply.

A ‘Stablecoin’ is a cryptocurrency linked to a reserve asset such as a fiat currency such as the US dollar or the euro, a commodity or other cryptocurrencies. It is a tokenized version of the asset and can be subtly introduced into a blockchain ecosystem to facilitate seamless pass transactions, improve arbitrage and exchange of value.

An advantage of stablecoins or stable coins is that they are popular as a refuge when there is ‘turbulence’ in the cryptocurrency markets., and are a common medium of exchange, often used by traders to move funds and speculate on other cryptocurrencies. In theory, they are supposed to have a fixed value (around $1) so they can be a reliable store of value, in contrast to the extreme volatility of bitcoin, ethereum, and others. Therefore, when a stablecoin shakes, the cryptocurrency market shakes more strongly than when, for example, a Bitcoin or an Ethereum register losses. And that’s what happened this week.

Stablecoin TerraSD

TerraUSD, one of the world’s largest stablecoins, lost a third of its value on Tuesday, spooking crypto investors and contributing in part to bitcoin’s plunge below $30,000 for the first time in 10 months. TerraUSD, also known as “UST”, is one of the so-called algorithmic stablecoins, one of the largest by market capitalization. On Tuesday it broke its 1:1 relationship with the dollar and fell as low as 67 cents, according to pricing site CoinGecko.

The token rose to fame earlier this year in 2022 when the nonprofit Luna Foundation Guard, a subsidiary of Terraform Labs, the company behind TerraUSD, pledged to amass $10 billion in bitcoin to support its link to the dollar. By Tuesday afternoon, TerraUSD had slightly rebounded to 91 cents and ranked as the 10th largest cryptocurrency in the world by market cap, according to CoinGecko.

Friday the 13th of cryptocurrencies

Unlike other stablecoins that have reserves in traditional assets, TerraUSD relies on an algorithm that moderates supply and demand in a complex process that involves the use of another balancing token, Luna.

But that same Tuesday there was a huge sell-off when the value of the Terra stablecoin suddenly decoupled from the US dollar. His value plummeted from $1 (where it was always meant to stay) to 60 cents. On Wednesday it plunged again, dropping its value to 20 cents on the dollar. Users with investments in Terra and Luna rushed out of panic to withdraw their money to avoid further losses, which increased the crash.

When Terra drops below $1, it can be exchanged for Luna tokens (with a small profit). In theory, this is intended to keep the value of both stable. According to ABC News, “it’s basically like printing money out of thin air, through a complex mix of “smart contracts”, to make sure that the value of each UST token stays as close to $1 as possible. But the problem was that these complex algorithms somehow failed spectacularly.”

moonfall

Luna crashed at the same time as UST, in what analysts have described as a “spiral of death”. Essentially, investors rushed to liquidate their digital assets faster than the stabilizer algorithmic” could kick in. The price of the “sister” token fell from about $86 earlier this week to just 0.003 cents on Friday.

In other words, Luna has crashed 100%, going from over $80 per token a week ago to zero on Friday, destroying around $28 billion of value in a matter of days. Investors suffered unprecedented losses as Luna’s market value plummeted from $40 billion to around $500 million, triggering a sell-off and a crisis of confidence throughout the cryptocurrency market.

The Terra bankruptcy sent a huge shock to the cryptocurrency market, contributing to bitcoin and ethereum suffering sharp declines on Thursday. However, both cryptocurrencies rallied around 10% on Friday.

recover from the fall

Do Kwon, co-founder of the company behind the token, Terraform Labs, announced a “recovery plan” in a series of tweets, saying the company would seek additional outside funding and “I would rebuildTerraUSD to be collateralized. That means it would be backed by reserves rather than relying on an algorithm to maintain its 1:1 peg to the dollar.

“A bailout was to be expected, and UST becoming essentially collateralized is the only outcome that makes sense,” said Joseph Edwards, chief financial strategist at crypto firm Solrise. In this week alone, the Terra blockchain has been frozen twice. Previously, on Thursday, Terraform Labs briefly stopped the network to prevent any hacking.

Dozens of other cryptocurrency exchanges, including FTX, Crypto.com, KuCoin, OKX, and CoinDCX, have taken action in recent hours to deal with the incident.. “An exponential number of new LUNAs were minted due to flaws in the Terra protocol design. Their validators have suspended their entire network, which has made it impossible to make deposits or withdrawals to or from any exchange.Changpeng Zhao, founder and CEO of Binance, noted in a Twitter thread.

Some of our users, unaware of the large amounts of LUNA newly minted off the exchange, started buying LUNA again, not understanding that as soon as deposits are allowed, the price is likely to crash further. Due to these significant risks, we have suspended trading.”

The volatility of cryptocurrencies

In its bi-annual Financial Stability Report on Tuesday, the US Federal Reserve warned that stablecoins are vulnerable investors’ actions because they are backed by assets that may lose value or become illiquid or illiquid in times of market stress.

They point out that “increasing use of stablecoins to meet margin requirements for leveraged trading in other cryptocurrencies may amplify stablecoin demand volatility and increase redemption risks”.

Stablecoins, as an asset class, have generally benefited from the volatility of the cryptocurrency markets. In fact, up to three stablecoins are now found among the top 10 cryptocurrencies by market capitalization, and TerraUSD ranks eleventh. Other major stablecoins, such as Tether and USDC, claim to be backed by real assets and thus are not vulnerable to the same issues that have plagued TerraUSD.

But the cryptocurrency market in general has been affected by declines in traditional financial markets. Luna’s collapse has even brought with it activations of telephone lines to dissuade those who have expressed the idea of ​​suicide after having lost their assets. The case of TerraUSD and Luna brings back to the fore the unstable game of cryptocurrencies, which one day can be making you rich and suddenly lose everything.

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