Economy Matter

Terraform Labs: The ‘rocket’ that crashed to the ground

How did a cryptocurrency doing magnificently in the markets suddenly crash so hard? And how did it take the rest of the market down along with it?

9 May 2022. Terra Luna, one of the most popular crypto coins at the time which had ‘moon-ed’ 4000% to $120 from its value just a year before, had crashed all the way to less than a dollar per coin. It was horrific, those that were lucky lost their whole investment in the coin, those who were less fortunate lost their whole life savings. Some investors (Trigger Warning) contemplated suicide because they had lost virtually all of the money they had.

It wasn’t only individuals who were suffering, but the market was too. There was a total liquidity crisis in the cryptocurrency space that caused an even more catastrophic loss of value with other currencies. Estimates show that $60 billion worth of money was wiped out in the crash, and billions of dollars in other coins were wiped as Luna dragged them all down. The crypto community still hasn’t recovered.

The man behind it all, Do Kwon, Founder & CEO of Terraform Labs, is now a fugitive residing in Singapore, avoiding arrest by the South Korean Government and Interpol.

But how did a cryptocurrency doing magnificently in the markets suddenly crash so hard? And how did it take the rest of the market down along with it?

Read about the Luna case study below, and find out how to apply this in debates at the last part of this article.

What is Luna crypto exactly?

Terra is a blockchain network, similar to Ethereum or Bitcoin, that produces Luna tokens. Terraform Labs created the UST (Terra USD) coin to be an algorithmic stablecoin on the Terra network. While other stablecoins (USDC or Tether) are fiat-backed, the UST would not be backed by real assets. Instead, the value of UST would be backed by its sister token, Luna.

Stablecoins are supposed to be safe havens in the crypto space because they are supposed to always be worth about 1 USD. The goal was to give investors a stable way to store value, unlike with other coins (like ethereum). Luna was Terra’s native token on the blockchain. It worked like ether on the Ethereum network. In the Terra network, Luna played two main roles: being a platform to pay for Terra network transaction fees, and keeping Terra’s stablecoin peg in place.

How much was LUNA worth before the crash?

In April, a Luna coin was worth about $116, but by the time it was taken off the market, it was worth only a fraction of a penny. Before that, the coin went from being worth less than $1 at the beginning of 2021 to making a lot of people crypto millionaires in less than a year. This made Kwon a cult hero among (some) small-time cryptocurrency investors. There were a lot of stories in the news about how Luna helped regular people get rich.

The price of the Luna token went up 135% in less than two months, reaching its highest point in April 2022. The biggest reason was that you could put your USTs on the Anchor lending platform and get a 20% annual return. Many experts thought that this ridiculous rate couldn’t go on for long.

The Terra blockchain was used to build the Anchor Protocol, which was a decentralized market for money. This platform became popular because UST holders who put their tokens on the platform got a 20% return. Then Anchor would give the deposit to another investor as a loan. Many doubters wondered where the money to pay these rates came from. Some people thought this was a clear Ponzi scheme, because rates were so high. At one point, as much as 72% of UST was put into Anchor because the platform was the main reason why Terra was in demand.

What went wrong with UST?

Before we look at this crypto disaster, it’s important to talk more about stablecoins. A stablecoin is tied to a currency that is more stable, like the US dollar. Both USDC and Tether are linked to USD. Stablecoins are used to protect against fluctuations in the cryptocurrency market. Let’s say that the price of Ether is $1,000. One Ether could be traded for 1,000 USDC tokens. When investors think the cryptocurrency market is going to go up, they put their money in stablecoins to protect their assets.

The UST coin wasn’t backed by a real US Dollar. Instead, it was a stablecoin that was based on a set of rules. People thought that Terraform Labs could keep the UST peg without the USD as a backstop by using smart mechanisms and billions of Bitcoin reserves.

You have to burn Luna in order to make UST. So, when the price of a Luna token was $85, for example, you could trade one token for 85 UST. That LUNA coin would then be burnt (taken off the blockchain) and converted into the money you traded in.

For UST to stay at its current value, one UST could always be exchanged for $1 worth of Luna. If UST went down, traders who bought UST and then traded it for Luna could make money, since Luna would still be at 1 USD.

Even though, this sounded remarkable on paper, UST was risky because it was not backed by cash, treasuries, or other traditional assets like the popular stablecoin tether. The value of UST was linked to Luna through algorithms, which made it stable. Many experts didn’t believe that an algorithm could keep two tokens stable.

On May 7, both Luna and UST crashed once UST’s value went well below 1 USD, meaning that it had lost its place as a stablecoin.

Why did LUNA crash?

The Luna cryptocurrency’s connection to TerraUSD (UST), the algorithmic stablecoin of the Terra network, was what caused it to crash.

On May 7, more than $2 billion worth of UST was unstaked (taken off the Anchor Protocol), and it was quickly sold for hundreds of millions of dollars. It’s not clear if this happened because interest rates went up or because someone tried to damage the Terra blockchain. The big sales drove the price of UST down from $1 to $0.91. So, people started trading 90 cents worth of UST for $1 worth of Luna.

Once a lot of UST had been sold, the stablecoin started to move away from the UST. In a panic, more people sold their UST, which caused more Luna to be made and more Luna to be in circulation, further devaluing the currency because it was now diluted (too much supply compared to demand).

Following this crash, crypto exchanges started to delist Luna and UST pairings. Long story short, Luna was left behind because it was no longer useful.

What happened when Luna crashed?

The Luna meltdown had an effect on the whole cryptocurrency market, which was already very unstable and having problems at the time. The crash of the Luna, and the perception of market instability coming from it, is thought to have caused the price of bitcoin to plummet and the value of all cryptocurrencies to drop by about $300 billion.

This was possible inherently because of how cryptocurrencies function. They aren’t backed by anything, so the price they trade at is determined by the whims of traders. This means that when traders see a red flag, or a perception of instability, they will sell immediately sell off, rapidly decreasing the value of the coin. Moreover, cryptocurrency trade volumes are still nowhere near as big as conventional securities such as stocks or bonds, meaning that a relatively small sell off can cause prices to fluctuate. A huge sell off, like what happened to Luna, can effectively wipe its value.

Bottom Line

As you can probably infer from reading this article, how cryptocurrencies function is very complex and sometimes quite hard to grasp. That effect was intentional. It was to show how the average investor and person probably does not fully understand how the cryptocurrency they are buying really works, and hence do not understand the risks of their purchase until it is too late. Note that we have only discussed how one particular cryptocurrency works and there are still many other coins, all with different ways they function, all with different networks, operators, pegging to stablecoins, etc.

The biggest takeaway you should take from this article is how to argue how volatile cryptocurrencies really are. Ultimately, it should boil down to three things:

  1. Cryptocurrencies are volatile because their value purely comes from traders’ whims and perceptions of markets and coins. This combined with the small volume trade means that prices are astoundingly volatile.
  2. Cryptocurrencies all have different complex mechanisms to run. Most buyers do not really understand what they are getting into because of how complex and opaque cryptocurrencies are. In this case, Luna’s lack of transparency and the investors’ lack of understanding about where the coin actually gets its value, caused a disaster.
  3. Just one Cryptocurrency crashing can take down a whole market with it, just like how Luna did in May.

So, there it is. A short case study on LUNA, probably the biggest story depicting crypto volatility and instability. Of course, besides LUNA, there are a multitude of other coins and stories which bear similarities to this one, and I suggest you have a look into those too!

Related motions

  • This house supports the rise of the use of cryptocurrencies (e.g. Bitcoin, Ethereum, USDT) in financial transactions.
  • This House Believes That cryptocurrencies have done more harm than good.
  • In 2022, a cryptocurrency named Luna crashed from 120 USD to just one cent. 17 Billion USD was wiped out in the crash. This House Would prosecute Do Kwon, the founder and CEO of Terraform Labs.

Further reading

The information in this article is a compilation of several sources, which are listed below. We recommend you read them for further understanding of the topic.

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