In May 2022, Terra, a popular blockchain protocol supporting decentralised Stablecoins pegged to fiat currencies and using Bitcoin reserves to protect this peg, lost over 99% of its value. This triggered one of the most brutal collapses of the crypto markets in recent memory.
In the second week of May 2022, flagship digital assets Bitcoin and Ethereum shed almost 40% of their value in a matter of days as crypto markets experienced a severe downturn, bleeding out over $600 billion. Bitcoin traded at $25,400 on May 12 from $40 just a week earlier, while Ethereum almost lost half its value, declining from $2900 to $1700 in the same period. Younger alternative coins fared worse as the crypto industry descended into waves of panic selling and massive liquidations.
Estimated value lost in crypto in 1 week during the May 2022 crypto crash
Perhaps significantly, crypto wasn’t the only industry on a slide. Crypto’s messy week of losses happened amid a fallout in global stock markets as inflation and post-pandemic recession deepened. Global indices were at yearly lows while inflation in parts of Europe and the Americas at their highest in decades.
Despite the circumstances surrounding the event that see Bitcoin reacting to the same dynamics weighing down on risky assets globally, there appears to be an obvious scapegoat in Terra. A blockchain payment platform which also consists of two algorithmic stablecoins, Terra virtually lost all of its value in this period, losing tens of billions of dollars in value and wiping out the portfolios of thousands of crypto investors. Its disintegration sent further shockwaves through crypto markets, exacerbating a sell-off that has battered investor confidence in the proposed volatility solution of stablecoins and cryptocurrency in general.
To help make sense of what happened with Terra, it might be helpful to first understand what a stablecoin is. At its most basic, a stablecoin is a cryptocurrency whose value is pegged to another currency. The most popular stablecoins include Tether (USDT) and USD Coin (USDC) – both tied to the US dollar.
Stablecoins were meant to be a solution to cryptocurrency’s extreme volatility and provided a way for investors to preserve their holdings at a more predictable value. For instance, instead of holding Bitcoin that will swing up and down in value, investors could convert their crypto to USDT, since 1,000 USDT will always be exchangeable for 1,000 US dollars (with very minor fluctuations).
Now, the Terra stablecoin, TerraUSD (UST), differs from regular stablecoins like USDT as part of a new generation of so-called algorithmic stablecoins.
Stablecoins such as USDT and USDC are backed by actual US dollar reserves, theoretically in a 1:1 ratio. This means that for every USDT or USDC issued, the issuers must also have 1 US dollar held in reserve. Actual companies must manually manage this balance – USDT is managed by a company called Tether, while USDC is managed by a company called Centre.
But stablecoins have historically been problematic. Because they are still centralised forms of currency, they have not been able to be fully transparent with their inner workings and are seen to be vulnerable to manipulations from political and commercial interests.
An algorithmic stablecoin like Terra’s UST, however, opts for a more “decentralised” form of stablecoin, using highly sophisticated computer algorithms — and Bitcoin reserves instead of US dollars – to maintain a dollar peg by automatically expanding or shrinking its supply according to prevailing market conditions. It is also meant to be governed in a decentralised manner, making it resistant to possible manipulations.
The Terra network, much like Bitcoin or Ethereum, verifies transactions on its network and produces or mines its own native cryptocurrency, called LUNA. Then, to create the UST stablecoin, LUNA must be “burned” or swapped. A single LUNA token, when burnt, would create a UST tokens equal to its value in US dollar.
So if LUNA’s value were $80, burning 1 LUNA would create 80 UST worth 80 US dollars. Conversely, if the Terra network needed to create 1 LUNA, 80 UST would need to be burnt.
The concept here was a simple deflationary one. As UST rose in demand, the network would burn more LUNA, making its supply more scarce and more valuable.
So why would UST be in demand?
Terra’s creators sought to encourage traders to burn LUNA to create UST by offering a high-yield staking offer for UST – 19.5% APY to be precise. In other words, if you committed your UST to stake at Terra, you could be earning 19.5% interest on UST a year.
This proved to be a popular staking investment. Buy LUNA, burn it for UST, and stake the UST for almost 20% returns annually. Before the May 2022 crypto crash, some $14 billion in UST was staked in this scheme. By then, LUNA was the darling of crypto – priced $15 at issue in May 2021, LUNA was trading at $120 just a year later.
At the core of UST’s peg was this: you could always exchange 1 UST for $1 worth of LUNA.
Thus, even if UST traded at $0.99 (the common extent of stablecoin variance), you could still profit by buying UST at 99 cents and exchanging it for $1 in LUNA, for a 1 cent profit.
The issue then is the value increase effect magnified by this kind of trading, since buying UST raises its price, while burning UST to obtain LUNA during exchange contracted UST’s supply. Because demand rises while supply decreases at the same time, the price pressure on UST is to go up. This requires active intervention from Terra to preserve the $1 peg.
This is where the Bitcoin reserves that Terra uses comes in. The reserves were managed by a consortium called the Luna Foundation Guard (LFG). LFG had purchased about $2.3 billion of Bitcoin for its reserves. If UST price went above $1, LFG would sell UST to bring the price back down to parity, growing its reserves. Conversely, if UST price went below $1, LFG would buy UST with the reserves to return it to parity.
On May 7, 2022, LUNA started the Saturday trading at $103.
Days before, global markets had already begun to feel the ripples of macroeconomic indicators. The US Federal Reserve had just announced the biggest interest rate hike in over two decades to combat inflation, and stocks and crypto were particularly volatile.
By May 12, LUNA wasn’t even worth 1 cent.
While some may be quick to label Terra’s capitulation as the worst-ever crisis for crypto — it is also true that there have been far more devastating crashes.
Just over two years ago, for example, in March 2020, Bitcoin slumped to $4,000, some 80% off its then all-time high of $20,000 in December 2017. The May 2022 crash also pales in terms of percentage loss when considering that Bitcoin once fell to $2 in November 2011 after achieving a high of $32 – a fall of 92%.
Nevertheless, LUNA and UST’s dual collapse has revived discussion surrounding several key issues in cryptocurrency markets. We take a look at some of them.
In the wake of Terra’s demise, Bitcoin also made an unwanted record of marking seven consecutive weeks of closing lower in price, something it had never done before. A well-known crypto market sentiment indicator called the Fear and Greed Index plunged to depths of “extreme fear” territory not seen in years.
This wasn’t a surprise, given the scale of losses caused by Terra alone.
LUNA and UST on their own caused over $15 billion in crypto value to disappear in a week. Though the facts are difficult to verify, social media is awash with accounts of many who were forced to sell off large parts of their crypto portfolio to make up for the damage of LUNA and UST exposure. This spillover, naturally, only served to drag crypto markets further down.
Terra also served as a stark reminder of just how vulnerable crypto was to what should have been isolated incidents within the space. Despite Bitcoin and crypto as supposed alternative investments or hedge assets, crypto markets have always reacted predictably to shocks in the industry. Some examples are the price crashes during the infamous hack of Mt Gox exchange in 2013, the ICO failures of 2018, and 2020’s stock markets Black Thursday.
This certainly hurts the argument that digital assets help to protect the value of wealth or even as a store of value.
Terra is far from the first stablecoin to have failed.
Though much smaller in economic scale of loss compared to the UST crisis, the likes of Basis Cash (#30 million market capitalization) and Empty Set Dollar ( $22 million market capitalization) also lost their respective pegs months after launch in January 2021. The former’s founder? Allegedly, the very same Do Kwon, Terra founder.
In June 2021, billionaire investor Mark Cuban lost his entire holdings in Iron Finance when its TITAN stablecoin overvalued and depegged.
Then, as pointed out earlier in this article, there are older questions and issues that have plagued more mature, centralised stablecoins like Tether and USDC for years. With the lack of transparency casting doubt over actual reserves held, there really is no objective, verifiable way to ascertain if these stablecoins are adequately collateralised.
Even with more decentralised stablecoins like Terra, transparency was difficult to achieve in practice. This became the case when the $2.3 billion worth of Bitcoin reserves didn’t work, leading to prominent figures in the space questioning if LFG used the funds appropriately.
Instead of the stated purpose of the reserves (to buy back UST), the Bitcoin was loaned out. What is certain is that LFG sent Bitcoin from its wallet to two exchanges: Gemini and Binance. What happened from there is unclear.
US Secretary of the Treasury Janet Yellen noted that the UST debacle proved that “there are rapidly growing risks” with stablecoins while crypto-friendly SEC Commissioner Hester Pierce also hinted at regulatory developments targeted at stablecoins.
The scarcely believable implosion of Terra is unlikely to deter the appetites of many other algorithmic stablecoins pushing to solve the volatility issue in crypto and seeking to empower decentralized finance.
But those that emerge later will surely have to contend with the increased attention from governments, banks and regulators.