Crypto's biggest crash: Terra, LUNA and UST crisis explained

The Terra blockchain, which features the UST (TerraUSD) stablecoin powered by the LUNA token, came to a halt for the second time in 24 hours amid the depegging of the UST stablecoin.

UST, which is programmed to maintain its dollar peg at $1, is now trading at $0.17, having lost its dollar peg and placing LUNA and itself into a death spiral.

LUNA has fallen 99.9 percent from its all-time high, trading at $0.00004586 at the time of writing. Its all-time high was $119.18 on April 5, 2022. In just over a month, over $41 billion in value has been eviscerated.

Many in the crypto industry regard the UST-LUNA fiasco as one of the worst crypto crashes ever, especially since UST had grown into the third largest stablecoin and LUNA had outperformed several major cryptoassets.

To understand what happened with UST and LUNA, let’s dive into the relationship between the two tokens on the Terra blockchain:

LUNA tokens are used for staking, mining stablecoins like UST on Terra. UST—an algorithmic stablecoin—is programmed to be minted when an equivalent quantity of LUNA is burned.

Unlike other stablecoins (USDT and USDC), UST is not backed by or pegged to real world financial assets like USD. As an algorithmic stablecoin, UST is built to control, regulate and maintain its value relative to the underlying asset, i.e, LUNA.

Essentially, LUNA tokens act as collateral for UST and are responsible for maintaining the stability of UST. UST is intended to maintain stability through a 1:1 mint and burn ratio with LUNA.

In simple terms, a user must burn an equal amount of LUNA to mint the equivalent amount of UST.

Although this makes the system more capital efficient (due to zero reliance on overcollateralisation or demand for debt), it makes UST’s survival fully dependent on LUNA’s market demand. 

Such dependence leaves LUNA and UST vulnerable to a ‘death spiral’, where both tokens plummet in value when the market loses confidence in them and redeems UST for LUNA in large volumes.

Depegging of UST

UST’s peg came under stress when an $85 million swap from UST to USDC in a Curve pool occurred on May 7. This shook the confidence of the pool’s liquidity providers, who began to withdraw some of their assets.

UST also began trading slightly below its peg on Binance (at $0.985).

In response, on May 8, the Luna Foundation Guard (LFG) announced it is deploying $1.5 billion of its reserves. It said it will loan $750 million of BTC to market makers to be sold to defend UST’s peg, and another $750 million of UST to buy back BTC after the volatility subsided.

However, by then, over $2.86 billion was removed from the Anchor protocol—a Terra lending protocol that pays out a yield of up to 20 percent to UST depositors.

UST’s peg continued to break, with its price falling to $0.60 on Binance the next day.

As more liquidity providers exited with whatever they had left, the only way for people to exit was by redeeming LUNA for UST (by minting LUNA en masse).

This set the death spiral in full swing, as the circulating supply of LUNA hyperinflated 8190 percent from 386 million to 32 billion in just over 48 hours. While UST depegged drastically down to $0.225 on Binance, the price of LUNA dropped to $0.01.

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Large-scale erosion of value

The large-scale erosion of value on the Terra network left it vulnerable to a 67 percent attack; a majority of attackers could theoretically collude to steal the remaining assets from the network while its liquidity and staking reserves were low.

Terraform Labs, which has built the entire Terra network, halted the blockchain temporarily on May 12, citing, “Terra validators have decided to halt the Terra chain to prevent governance attacks following severe $LUNA inflation and a significantly reduced cost of attack.”

Although the chain came back online for a few hours, it was “officially halted” a few hours ago, with validators now coming up with a plan to reconstitute it.

As the crypto world waits and watches for the LUNA-UST crisis to evolve, many retail traders and financial institutions with significant exposure to LUNA and UST have seen the value of their investments completely eroded.

UST, while claiming to serve as a decentralised medium of exchange, showed its model is fairly centralised - due to its reliance on LUNA. Further, some crypto analysts now believe the UST-LUNA crisis will influence and extend the depth and length of the current bearish sentiment in the crypto market.