What happened? The Terra debacle highlights the flaws plaguing the cryptocurrency industry

The past week has been a dark period in crypto history, with the industry’s total market cap falling to $1.2 trillion for the first time since July 2021. The cosmos-based protocol that powers a range of algorithmic stablecoins.

About a week ago, Terra (LUNA) was among the top 10 most valuable cryptocurrencies on the market, with a single token trading at $85. However, by May 11, the price of the asset had fallen to $15. And 48 hours later, the token has lost 99.98% of its value and is currently trading at a price of $0.00003465.

Due to the ongoing crash, Terra’s other partner offering, TerraUSD (UST) — an algorithmic stablecoin pegged 1:1 to the US dollar — has lost its peg to the dollar and is currently trading at $0.079527.

Terra’s ecosystem explained

What happened?  The Terra debacle highlights the flaws plaguing the cryptocurrency industry
What happened? The Terra debacle highlights the flaws plaguing the cryptocurrency industry

As mentioned above, the Terra Protocol is governed by the use of two main tokens, namely UST and LUNA. Network participants have the opportunity to mint UST by burning LUNA on the Terra Station portal. In short, you can imagine that the Terra economy consists mainly of two funds: one for TerraUSD and one for LUNA.

To preserve the value of UST, LUNA’s supply pool adds or subtracts from its coffers, requiring customers to burn LUNA to mint UST and vice versa. All of these actions are driven by the platform’s algorithmic market engine, making UST’s functional framework significantly different from that of its closest stablecoin rivals Tether (UDST) and USD Coin (USDC), both of which are directly backed by fiduciary assets.

To better illustrate how UST (or algorithmic stablecoins in general) works, it would be best to use a simple illustration. For example, suppose the value of UST is fixed at $1.01, then users are encouraged to use Terra’s exchange module to exchange $1 of LUNA for 1 UST, thereby earning a net profit of 0, 01 can collect $.

Now, when the tide turns and UST drops to $0.99, network users can do the exact opposite, resulting in the protocol not allowing some users to exchange $1 UST for $1 LUNA. This once hypothetical scenario is now a living reality, leading not only to the disintegration of the Terra Protocol, but also to the cryptocurrency industry’s bad reputation in the eyes of investors around the world.

Damage control, but in vain

As soon as LUNA and UST went into freefall earlier this week, protocol co-founder Do Kwon released a series of tweets announcing corrective actions to stem further bleeding. As an interim measure to counter the decoupling of UST from the dollar, Kwon strengthened burning UST, something we now know in hindsight didn’t work.

Kwon claimed that increasing the pool from 50 million to 100 million Special Drawing Rights (SDRs) and reducing the PoolRecoveryBlock from 36 to 18 could increase the protocol’s minting capacity from $293 million to a whopping $1.2 billion.

In short, by implementing the above changes, the Terra team was able to mint four times as many UST from scratch, a process now jokingly known as kwontative easing. Jack Tao, CEO of cryptocurrency exchange Phemex, told Cointelegraph that looking back, the signs of catastrophe around UST and LUNA have been there for quite some time.

For starters, he thinks the general idea surrounding algorithmic stablecoins is pretty flimsy itself, as these offerings lack any sort of real value. Second, the Luna Foundation recently made a lot of noise when Do Kwon announced that he would buy a total of $10 billion worth of Bitcoin (BTC) to serve as UST reserves. In this regard, Tao added:

“These purchases created an oversupply of UST that quickly began to decline as selling pressure built in LUNA and subsequently UST. Once this sale took place, the House Guard Fundación Luna had to dump their bitcoin to maintain parity. But, the knee-jerk selling pressure continued and all the assets involved began falling sharply.”

Tao added that the Anchor Protocol — a savings, lending, and borrowing platform built on top of the Terra Blockchain — which promised an unrealistic 20% annualized return (APY) on UST staking, also played a major role in the development played. As selling pressure mounted on UST, it lost its $1.00 peg and started falling uncontrollably:

“As Binance’s liquidity dried up, Curve’s two UST pools began selling UST and Anchor’s lending fell by over $1 billion. As a result, trust issues have been plagued the ecosystem in general, especially when it comes to stablecoins.”

Terra officially goes offline after the collapse, albeit briefly

On May 12th, Validators serve the Terra Network decided are collaborating to shut down all digital activity related to the ecosystem to mitigate potential governance attacks, especially as the network’s LUNA token recently fell below one cent.

Up to this point, the official Terraform Labs Twitter account revealed that all network activity stopped at block height 7,603,700. With LUNA’s value falling nearly 100%, the company’s spokesperson suggested that developers no longer trust its abilities to prevent third-party governance hacks. The downtime was short-lived, however, as the core Terra team announced that it would resume operations once validators could apply a patch that would disable any additional delegations.

As a result of the LUNA/USDT trading pair falling below the 0.005 USDT level, it was delisted from Binance. The move followed crypto exchange Huobi’s withdrawal of LUNA tokens just a day earlier. Before the mentioned events, UST was the third largest stablecoin by total market cap, behind only Tether and USD Coin.

A bad image for the industry as a whole

According to Tao, this whole episode will have a negative impact on the image of the cryptocurrency industry, especially in the eyes of investors. In particular, he believes the drop could result in lawmakers becoming tougher on decentralized stablecoins and even prompting many governments to aggressively explore creating their own centralized stablecoins and central bank digital currencies (CBDC), adding:

“Unfortunately, the LUNA situation will leave a bad taste in everyone’s mouth as it has caused many major altcoins to plummet in value. However, a more important aspect of this event is its timing. All of this happened at a time when there was a war raging in Eastern Europe, supply chains were tightening around the world, inflation and interest rates were rising.”

However, he admitted that all of this could have a small silver lining: the event could result in only the best projects surviving, with most incomplete platforms losing investor interest in a big way. “There will be a lot more controls from now on, and investors will feel comfortable choosing to only invest in the biggest cryptocurrencies like bitcoin, ether and solana,” he said.

So it will be interesting to see how this story unfolds further and what impact this incident has on the development/evolution of the cryptocurrency market in general, especially as the traditional financial system also continues to be plagued by an increasing number of financial pressures.

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