What Caused the Terra-Luna-Triggered Cryptocrash?
- By FXT
- May 17, 2022
- FXT Analysis
The cryptocurrency market suffered a devastating crash last week which destroyed billions of dollars in value, and left large numbers of hapless investors financially devastated.
At the epicentre of the crash was the collapse of Terra – formerly one of the world’s most valuable stablecoins – and its sister token Luna, which led directly to the destruction of nearly USD$45 billion in market capitalisation.
Its collapse has arrived following a trying period for even prestige cryptocurrencies such as Bitcoin and Ethereum, both of which have suffered declines in tandem with the poor performance of US stocks.
The Terra/ Luna crash further worsened their fortunes by undermining broader market confidence in crypto, with Bitcoin plunging at one point to beneath the $25,500 threshold during Thursday trading.
Both Terra and Luna are the creation of Singapore-based Terraform Labs, whose CEO Do Kwon is an alumni of Stanford University, as well as a former software engineer at Apple and Microsoft.
Terra is an algorithmic stablecoin – a form of cryptocurrency which is pegged to another currency or asset in value.
In the case of Terra, the peg was at a 1:1 ratio against the greenback, meaning that at all times a single Terra should be exchangeable for a single US dollar.
Traditional central banks maintain the pegs of the statutory monies they issue by holding reserves of the asset or currency against which they are pegged – whether it be gold or the US dollar.
Holders of the statutory money can then exchange this money for the asset or currency that backs it in accordance with the peg ratio. Central banks can also adjust monetary supply via forex operations in order to help maintain stability.
Most stablecoins follow the model of central bank money by also employing a system of cash reserves, to ensure that they have sufficient liquid assets for redemption.
With Terra however, Terraform Labs did not hold huge reserves of greenbacks in order to maintain the stablecoin’s peg to the dollar.
Terraform instead employed a “burn and mint equilibrium” which involves the use of two tokens, and automated adjustments to their respective supply conditions to keep the peg going.
Under the scheme if Terra sunk beneath USD$1 in value, it would be swapped for Luna, which would ensure that prices remained stable.
These automatic adjustments are implemented via pre-programmed “smart contracts” – one of the key innovations made possible by the development of cryptocurrencies.
Last week however, both Terra and Luna saw their prices drop simultaneously, leading to a “death spiral” in prices that forced the removal of the peg.
Terra saw its price plunge beneath $0.20, while Luna fell even further, from around $86 at the start of the week to a mere $0.003 on Friday. Luna’s crash brought its market value down to $500 million from $40 billion previously.
Speculation is rife on the Internet as to the precise cause of the Terra/Luna crash, with most theories pointing to concerted short-selling by a group of powerful traders.
Some have even pointed the finger at US hedge funds BlackRock and Citadel Securities, both of whom have denied the accusations.
Whoever is responsible appears to have purchased around $1 billion in Terra, while simultaneously shorting Bitcoin – essentially betting that its price would fall.
They then waited until trading levels were low before selling off Terra in vast volumes. Because the “burn and mint equilibrium” dictates that every time a Terra is sold a new Luna is minted in order to keep heir levels even, Luna volume increased.
Due to low trading activity however, buyers were scarce on the ground, so price declines became reinforcing because people were selling off Luna in a panic.
The selling activity also prompted the Terra algorithm to sell off some of the $3.5 billion in Bitcoin held as collateral, in a futile bid to prop up its peg against the dollar.
The resulting drop in Bitcoin prices enabled short-sellers to reap profits, while roiling the rest of the crypto market.
The crash of crypto caused by the collapse of Terra and Luna has not just destroyed market value – it has also had the effect of destroying lives and driving devastated investors to the brink of suicide.
Some users on Reddit have reported the loss of their entire life savings, prompting cryptocurrency sub-Reddits to post information on suicide prevention hotlines at the top of their pages.