Fall Of Luna: Everything you need to know about the Terra Luna Crash
Along similar lines, something really interesting yet unfortunate happened in the space which wiped out billions in revenue and shook the entire market. The incident is of course the infamous crash of Terra Luna.
Terra (LUNA) was a token created by Do Kwon which ran on the Terra blockchain. It was supported by the Luna Foundation Guard (LFG). The purpose of Luna was to create its own ecosystem (Terra ecosystem) and a few use cases involved, paying network fees, peg stablecoins, providing staking rewards in PoS (proof of stake), acting as a governance token, etc.
Since it was an ecosystem of its own, it even had its own stablecoin UST as a backing. Being a stablecoin UST was pegged to the US dollar which simply meant 1 UST = $1 UST. Maintaining its peg was also essential for it to act as a transactional medium in the terra ecosystem.
Stablecoins in general (USDT, DAI, etc.) maintain their peg to the US dollar via a collateral-based system. This means if there are 1 billion USDT tokens in the market then there are 1 billion dollars locked in a bank somewhere as collateral. But in the case of Luna things were different.
Working of Luna
Luna followed the system of arbitrage where 1 dollar of Luna could be exchanged for 1 dollar of UST. The price peg too was maintained by a seesaw mechanism. The mechanism worked in the following way:
If the price of UST goes (slightly) above a dollar, Luna tokens are burned to decrease supply;
A decreased supply results in a price increase for Luna which leads to the minting of more UST to balance out the price;
As more and more UST is minted, there is an increase in the supply of UST tokens;
The increased supply of UST brings the price down back to 1 USD.
Now if the price of UST went below a dollar then the same mechanism was followed except this time UST tokens were burned (decreased supply) and more Luna tokens were minted (increased supply) which eventually brought the price back up.
Furthermore, in order to avoid excess liquidity in the market, it even offered holders the option of locking their UST on the Anchor protocol and earning up to 20% interest. The scheme was so successful that at one point in time around 70% of the UST tokens were locked in Anchor!
With fundamentals well in place, Terra’s price soared and went from around $0.4 to over $100! It instantly became one of the top 10 cryptocurrencies of the time.
The Problem and The (temporary) Solution
In addition to running on Terra blockchain, UST also ran on other blockchains like Ethereum, Solana, Binance Smart Chain, and Harmony. Now if anything happened to UST other blockchains would get affected too, UST was therefore contagious.
Thus to tackle this issue, Do Kwon bought $3.5 Billion worth of BTC as a backup to collateralize UST.
One of the curses that come when a project soars is that it grabs the attention of attackers. The case of Terra was no different. All that one needed to do was find one loophole and use it to their benefit. In this case, the attackers found it and much to our surprise it was their very own seesaw (mint and burn) mechanism that had a major fundamental flaw.
Turns out the problem with the mechanism was that if the price of UST stayed below a dollar then the supply of Luna would keep going up and up, while the price would keep coming down and down. The lower the price of UST went, the more and more Luna had to be minted for regaining the peg. The more the Luna supply the further the price would drop. This entire technique is called the Death Spiral Technique where the downfall of one affects the other. Now all that was left to do was find a way to keep the price of UST down for “enough” time.
The Final Crash
As it turns out the attackers found a way to bring down UST and make it stay below the dollar. They did so by draining the 4pool on Curve which had a value of about $250 million! Next, they moved to crypto exchanges that supported UST and essentially became ‘unlimited’ suppliers of UST. They gave out UST for any price asked. If someone wanted it for $0.99 they were given 1 UST for that price. If someone wanted it for $0.98 they were given it. It is reported that over around 2 billion dollars worth of UST was used in this practice! Sufficient to say, giving out UST at any price, and selling at a loss worked in the favour of attackers and UST ultimately lost its peg. What followed next was the death spiral as explained earlier. Within 24 hours Luna lost more than 50% of its value. The continued mint and burn process made the thing even worse.
Such a terrible dip caused a lot of panic in the market and what followed next was panic selling in masses. LFG even sold their collateralized BTC but it was already too late and it just wasn’t enough to bring the price back up. Since there was panic in the market, a lot of other assets (BTC/ETH) were sold by investors to average out their losses but the attempt went in vain. The panic selling only increased liquidity in the market and the entire crypto market took a massive hit. Since UST also ran on other blockchains, they too were severely affected by the de-peg. To put into perspective how bad the crash was; a million dollars worth of investment in Luna at its all-time high would be now (at the time of writing) less than $3!
Aftermath & Impact
The catastrophic crash caused major crypto exchanges to put a stop to UST trading. A few even delisted both Luna and UST. The Terra blockchain too was halted twice to prevent any more losses but the damage had already been done. As for the attackers who sold everything at a loss it is assumed that they knew that their actions would crash the market. This is why they held massive shorting positions on major crypto coins and when the crash happened their shorting made them recover their money severalfold.
The entire debacle made matters worse for crypto adoption and negatively impacted it in the present. The entire incident is also a testimony to the fact of how important it is to DYOR (Do Your Own Research). But on a positive note, several people will now be extra careful before jumping into something new. In addition to that one thing is for certain the era of Web 3 might have encountered a hiccup but it is here to stay!
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