Alongside futures and options, crypto has always instrumentally been one of the most volatile asset classes on any investment portfolio. Recently, a huge splash had rocked (and flipped over) many boats in the crypto market: the Terra/Luna crash.
Confused? Don’t worry – this article will help shed light on one of the largest outcries of recent crypto market history.
To put it simply, there are two coins at play here:
- Terra Luna, also known as Luna, regular crypto.
- Terra USD, also known as UST, is an 'algorithmic stablecoin' designed to be pegged to USD$1 (S$1)
The way the algorithm works is pretty simple: You can burn USD$1 worth of Luna and get one newly printed UST, or you can burn 1 UST to get 1 dollar's worth of Luna. That's really all there is to it.
How did arbitration crash the value?
Firstly, how exactly does arbitrage work?
|State of UST||Arbitrage in action||Result|
|When UST is slightly >$USD1||People burn Luna to get $USD1 worth of UST and sell for profit||Price of UST brought down to $USD1|
|When UST is slightly||People burn UST to get $USD1 worth of Luna and sell for profit||Price of UST brought up to $USD1|
In essence, traders utilise arbitrage opportunities to profit, which results in the price of UST to always hover around $USD1.00 exactly.
So how did the situation unravel?
Well, there are plenty of speculation for the initial dip in UST price, but the resulting mechanism was as follows:
When the price of UST dropped below 1 dollar, people started arbitraging it. Hard. This means they burn the UST for 1 dollar of Luna each, then sell the Luna for a profit. The problem is that selling all this Luna plummets the price.
If you pay 90 cents to buy a UST and trade it for 1 dollar's worth of Luna, but that Luna drops to 80 cents by the time you've sold it, you're not arbitraging anymore, you're losing money. As a result, the collapsing price and demand for Luna broke the arbitrage system that kept the peg in place.
Seeing that the peg was breaking, scared UST holders started massively selling off UST directly for dollars, or burning UST for Luna and selling that off. This made the price for both Luna and UST crash even further.
And remember: If you burn UST you get USD$1 worth of Luna, regardless of how much Luna that is. Hence, the further the price of Luna dropped, the more Luna each UST creates. The more Luna is created, the further the price drops.
The final result is a downward death spiral, where the price crashes of both cryptos feed into each other’s destruction.
The impact of the crash
When all is done and dusted, Luna is now worth less than a cent – an astounding 99.99 per cent price drop. Meanwhile, Terra UST, who used to faithfully follow the dollar, is now worth roughly 17 cents. The Terra/Luna crash also impacted the wider crypto ecosystem as a whole: Bitcoin and Ethereum both dipped to 11-month lows.
Some people profited handsomely, while others lost their life savings. As harrowing as the story of the crash is, it serves as a sobering reminder for any wannabe crypto investors: always do your own research, and never invest more than what you are willing to lose.
This article was first published in ValueChampion.