Terra LUNA explained: The basics of the Terra ecosystem
Terra is a Proof-of-Stake (PoS) blockchain leveraging Cosmos technology. Computer scientist Do Kwon and economist Daniel Shin launched Terra in 2019 through their company Terraform Labs. A non-profit Singaporean firm called the Luna Foundation Guard handled Terra's fundraising. The Terra blockchain created the USD stablecoin UST, the South Korean Won stablecoin KRT, and the LUNA cryptocurrency. A stablecoin is a cryptocurrency with a relatively stable price—this is achieved by “pegging” the coin to a currency, like the U.S. Dollar (USD).
Kwon and Shin created Terra with two goals in mind. First, Terraform Labs planned to use blockchain technology to create a fast and low-fee payment network. Second, the team wanted to launch dozens of "algorithmic stablecoins" that tracked fiat currencies—money backed by a country’s government—like the USD. These stablecoins would allow people to have the price stability of traditional cryptocurrencies, along with the properties of cryptocurrencies.
Unlike reserve-backed stablecoins like Tether (USDT) and USDC, Terra's stablecoins weren't backed by an equivalent amount of cash in a bank account. Instead, the Terra team used an algorithm and its LUNA cryptocurrency to create value for its stablecoins. That’s where the name for algorithmic stablecoins comes from—they’re coins backed by an on-chain algorithm that handles supply changes between the stablecoin and the cryptocurrency, propping up their value (in this case, the LUNA token).
The main benefit of Terra's algorithmic stablecoins was their decentralization. Instead of relying on companies like Circle or Tether Limited, these new stablecoins promised to run solely on code. This means that a third party can’t freeze or control assets that may become antagonistic. Crypto enthusiasts were hopeful Terra's algorithmic model would provide a decentralized alternative to centrally issued stablecoins.
As Terra gained attention, hundreds of developers created decentralized applications (dApps) on the Terra blockchain. Many of these dApps leveraged the stability of Terra's UST stablecoin to offer decentralized finance (DeFi) services. Most significantly, Terra's Anchor Protocol offered a high-yield crypto savings account to anyone who deposited UST onto its platform. At its peak, Anchor Protocol held $14 billion worth of UST deposits—equivalent to 80% of UST's circulating supply. The popularity of Anchor helped propel UST's market cap to a high of $18.6 billion in 2021.
How does the UST stablecoin work?
Terraform Labs created a system allowing traders to create ("mint") or destroy ("burn") UST and LUNA. Since no physical reserves backed UST, the LUNA token served as a form of crypto collateral. Whenever $1 of LUNA was minted, $1 of UST was burned, and vice versa.
Arbitrage traders—those whose trading practice exploits price discrepancies in one asset across multiple exchanges—took advantage of small deviations in UST's value from $1. By encouraging these trading activities, Terraform Labs hoped to keep UST's supply in check whenever it began straying from its $1 peg.
For instance, if UST's market price went to $1.10, arbitrage traders could burn $1 worth of LUNA to mint $1.10 of UST. As more traders increased the supply of UST, the price fell to $1. By contrast, if UST fell to $0.90 per token, traders burned their UST to mint $1 worth of LUNA tokens for a 10% profit.
Arbitrage traders needed to sell their UST or LUNA immediately to realize these gains. This intentional sell pressure is partially responsible for LUNA and UST’s fast falls in 2022.
What else was LUNA used for?
Besides balancing the price of stablecoins like UST, LUNA served three other significant roles in the Terra ecosystem:
- Governance: LUNA holders could use their tokens to vote for or against upgrades to the Terra blockchain.
- Staking: Like other PoS chains, Terra relied on validators to lock their LUNA on the blockchain to confirm crypto transactions. Anyone who staked their LUNA on Terra's blockchain earned token rewards for their service.
- Transaction fees: To make transactions within the Terra ecosystem, developers and dApp users had to pay fees with LUNA tokens.
Explaining the 2022 crash: How UST depegged
Many speculative theories surround UST's crash, and all the details have yet to unfold. However, most crypto analysts believe two large transfers on the decentralized exchange (DEX) Curve Finance caused UST to lose its $1 peg. On May 7, 2022, Terraform Labs withdrew roughly $150 million worth of UST from Curve Finance. Simultaneously, an unknown crypto whale swapped $85 million worth of UST for another stablecoin called USDC. This intense sell pressure likely caused UST to trade below $1 on May 8.
Following news of UST's depegging, nervous investors began to sell their UST holdings for other cryptocurrencies or cash. Within just two days, roughly $9 billion of UST left the Anchor Protocol, causing UST's price to slip even further into the red. Although the Luna Foundation Guard sold 80 thousand Bitcoins to prop up UST's price, it wasn't enough to stave off the immense sell pressure in the crypto market.
In addition to the increased selling of UST and LUNA, arbitrage traders kept minting $1 worth of LUNA while burning UST tokens. Since UST's price never reached $1 again, LUNA tokens entered a never-ending hyperinflationary cycle known as a "death spiral." Although extreme, there are several other examples of spiraling incentives in economics. Analysts at the blockchain firm Glassnode estimate LUNA's supply grew from 343 million to roughly 6.53 trillion in a few days—LUNA's annual inflation rate reached 99,263,840% as arbitrage traders kept minting and selling these tokens.
To prevent any further damage, Terraform Labs temporarily paused the Terra blockchain twice. The Terra team also halted its "mint and burn" mechanism to stop LUNA's token supply from increasing.
Days before UST's fall, LUNA was trading for roughly $80 per token. By May 12, both LUNA and UST were worth less than one penny each. In total, the collapse of UST and LUNA drained $40 billion from the crypto ecosystem.
What is Terra 2.0?
In the weeks after UST's depegging, Terra's co-founder Do Kwon proposed creating a new PoS blockchain called Terra 2.0. The Terra 2.0 chain is an offshoot of the original Terra network with a distinct ecosystem. Anyone who held LUNA or UST before, during, or after UST's fall was eligible to receive crypto airdrops into their digital wallets.
The Terra community voted in favor of Do Kwon's proposal, and the Terra 2.0 chain went live on May 28, 2022. To distance itself from the old Terra blockchain, the community re-named the original LUNA cryptocurrency "LUNA Classic" (LUNC). UST is now known as "UST Classic" (USTC), and the primary cryptocurrency on Terra 2.0 is called "LUNA."
Unlike the original Terra blockchain, Terra 2.0 isn't used to create decentralized stablecoins. Instead, Terra 2.0 focuses on attracting dApp developers, similar to other smart contract chains like Cardano and Solana. Since Terra 2.0's LUNA isn't tied to algorithmic stablecoins, it doesn't have the same risk of a "death spiral,” and the new LUNA token doesn't have LUNC's hyperinflated supply.
The impact of the LUNA and UST fall
Immediately following UST's depegging, more international regulators scrutinized the safety of stablecoins. Lawmakers expressed concerns over algorithmic stablecoins like those on Terra's blockchain. The U.S. government introduced a bill to make algorithmic stablecoins illegal, and the European Union proposed restrictions on stablecoin transactions.
Although Terraform Labs didn't invent algorithmic stablecoins, UST was one of the most widely used in the crypto industry. Understandably, more developers and lawmakers are skeptical of the technology used to support failed tokens like UST. Despite the success of other algorithmic stablecoins, such as Maker's DAI, reserve-backed stablecoins remain the most actively traded in the cryptocurrency market. However, as DAI holds centralized cryptocurrencies such as USDC in reserve, it’s not fully decentralized.
The Terra collapse also heightened the sour sentiment in 2022's crypto market. The global crypto market cap fell from $1.8 trillion in May to $800 billion in August, and many multi-billion-dollar companies tied to UST filed for bankruptcy. As crypto firms like Celsius, Voyager, and Three Arrows Capital went under, the 2022 crypto bear market intensified. Survey data suggests several investors lost faith in cryptocurrencies following Terra's fall. In November of 2022, 43% of Americans had an unfavorable opinion of cryptocurrencies, a sharp 18% increase from March of 2022.
The LUNA-UST collapse exposed many vulnerabilities in algorithmic stablecoins. While the idea of decentralized stablecoins appeals to many crypto fans, the technology behind these tokens is in its infancy. Anyone interested in algorithmic stablecoins must recognize these tokens are highly experimental. Crypto investors should always be cautious with ambitious and untested crypto projects.
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