Terra Stablecoin Loses $1 Peg, Faces Potential Collapse

How the Terra Stablecoin Lost Its $1 Peg and Brought Down Luna

As an algorithmic stablecoin, TerraUSD maintains its 1:1 peg with the US dollar via a balancing act involving its sister token, LUNA. Basically, whenever UST’s price dips below $1, the Terra platform burns UST and mints LUNA. If its price rises above $1, LUNA is burned and more UST is minted.

Sounds simple enough, but this dynamic was brutally ruptured last weekend. What appears to have happened is that two accounts withdrew around $500 million in various cryptocurrencies from Anchor, which is a DeFi protocol running on the Terra blockchain that can be used to earn yields from UST deposits.

This withdrawal caused a panic among UST holders who had deposited on Anchor. Users feared there wouldn’t be enough liquidity on the platform to cover their positions. Indeed, there was only around $300 million in exit liquidity, meaning that users could withdraw their UST only by depreciating its value. Given that there was around 14 billion in UST on Anchor at the start of the weekend, and only 9.8 billion by Monday, it’s unsurprising that UST’s price dropped from $1 on Saturday to $0.92 by the end of Monday.

Needless to say, this ‘de-pegging’ of TerraUSD had a snowball effect. For instance, Twitter was replete over the weekend with accounts of whales dumping UST on various exchanges and trading platforms.

It was around this point that the Luna Foundation Guard took steps to help the UST price. Having accumulated around $3.5 billion in bitcoin as part of its reserves, it began lending and spending this BTC, and currently has no BTC left. However, this injection of capital didn’t really have the effect of returning UST’s price to $1, since it repeatedly hit new lows.

TerraUSD’s price over the past seven days. Source: CoinGecko

While lending/selling BTC, as well as the LUNA and AVAX (Avalanche), in its reserves didn’t prevent the crypto equivalent of a bank run on UST, it did have the effect of depressing the respective prices of the three reserve cryptocurrencies concerned.

BTC dropped to $30,000 on Tuesday and Wednesday, while AVAX reached as low as $35, having been at $68 as recently as May 5. Worse still, LUNA went from $87 on May 4, to $0.81 on May 11, representing a drop of around 99%.

Are TerraUSD, Luna Finished? And What Risk to the Cryptocurrency Market?

A loss of 99% is pretty staggering. For all intents and purposes, it’s as if LUNA has been wiped out as a cryptocurrency. And with UST sitting at $0.49 as of writing, there’s a very good chance that it too could collapse completely.

Needless to say, Terralabs appears to be doing all it can to return the stablecoin to its former level, but with the Luna Foundation Guard’s reserves declining by 97% in about a week, it seems to be running out of tools. Founder Do Kwon announced on Wednesday May 11 that it’s taking steps to burn more UST, thereby reducing its supply and boosting its price.

Source: Twitter

What the tweet above refers to is a plan to speed up UST burning and also accelerate the minting of new LUNA. This is a proposal that’s currently being voted on by Terra developers, with the voting period due to end in seven days.

Seven days may be too long for UST, given that it has already fallen as low as $0.33. Likewise, even if accelerated burning of UST and minting of LUNA may help restore the peg temporarily, it’s highly arguable that the current crisis has irrevocably ruined faith in the stablecoin. This is an argument being made by notable accounts on Crypto Twitter.

Source: Twitter

Because UST is a stablecoin, the fact that its peg has broken so violently may have permanently undermined trust in it. Maintaining a peg is the whole point of a stablecoin, and it’s conceivably very likely that many traders will be too scared to hold UST again, for fear that something similar will happen in the future.

What makes the Terra-Luna case interesting is that there’s speculation it’s depegging was the result of an ‘attack,’ or rather of manipulation. Basically, the idea is that certain traders — there are rumors of who it could be online — dumped masses of UST so that they could make a profit shorting bitcoin.

Such theories certainly haven’t been confirmed, but they chime with earlier — and now very prescient — warnings that Terra was vulnerable to a market manipulation-based attack. And the point is that, with TerraUSD losing its peg, it will now find it impossible to shake the perception that it’s vulnerable to exploits like this.

This is obviously very bad news for Terra, but it’s also bad news for the cryptocurrency market. Because when UST and LUNA completely collapse (assuming they will), confidence in cryptocurrencies will be shaken. A market already vulnerable as a result of unfavorable macroeconomic conditions will sink a little further, although hopefully, after the dust settles and UST is forgotten, it will begin a much-needed recovery.