With stock markets showing losses in recent months, the crypto market has not escaped the trend, with large devaluations in recent months. Something expected given the high volatility associated with crypto.
What was not expected by many was the collapse of the Terra blockchain, which in terms of market capitalization, was one of the largest. What failed, in particular, were its two main cryptocurrencies, Luna and UST, two highly interconnected cryptocurrencies.
To better understand the Terra ecosystem, it is necessary to understand that there is a direct relationship link between LUNA and UST(TerraUSD, a stablecoin).
As we have already explained here, a stablecoin is a cryptocurrency that tries to keep its value stable. Typically they set the value by mirroring the value of fiat currencies like the US dollar or Euro. There are a few different ways to mirror this value, one of them, the one chosen by the creators of UST is through an algorithm.
The UST keeps its value equal to the US dollar through a mechanism linked to another cryptocurrency on Terra, the Luna token, developed by the same creators as the UST.
It was created with the goal of being the other side of the UST to help keep the value of the UST fixed at 1$. This token unlike the UST can vary its value.
Luna and UST how they work
The relationship between these two cryptocurrencies is vital to how well they work. The main relation is the fact that to create UST it is always necessary to destroy (burn) Luna.
For example, let’s imagine that the value of the Luna token is 100$, if we so desired we could destroy that Luna token for the value of 100 UST, which in theory is worth 100$. By doing the reverse, the UST would also be destroyed.
The key concept of this protocol is the ability to exchange 1 UST for 1$ of Luna, regardless of the value of the UST. That is, if UST lost its value from 1$ to 0.5$, you could exchange that UST for Luna and profit 0.5$ for each UST exchanged.
If we use the previous example, by exchanging the devalued UST for Luna, we would profit and reduce the UST in circulation. According to the law of supply and demand, a reduction in the quantity of a product, assuming stable demand, would increase its value.
The opposite also happens and the price of the UST would increase. In these cases investors would exchange their Luna for UST, earning a return thanks to the higher price of UST. This would increase the UST in circulation, causing its value to decrease.
The problems of the Terra blockchain began and ended extremely quickly. It started with the sale of huge amounts of UST, which caused a devaluation to near $0.9. Investors saw this as a lucrative opportunity and decided to trade their UST for Luna.
In doing so they burn UST, which decreases the amount of UST and in theory increases its value. The problem was the daily limit of UST that can be burned and exchanged for Luna, about $100 million.
Due to this limit and the current state of the economy led many investors to simply cut losses and sell their UST, which caused further devaluation.
The Luna token, being the counterpart to the UST also suffered a huge devaluation. The sudden and voluminous exchange of UST for Luna created more Luna, causing that token to devalue.
In just a few days, Luna went from being worth around $100 to mere pennies.
This crash, aside from the obvious, had some contagion to other crypto assets like Bitcoin or Ethereum that devalued even further. It is estimated that in Luna and UST alone more than 15 billion Euros were lost.
It also raised doubts about the fragility of some stablecoins. Especially if we consider the size of this crash, something quite unexpected by some.
It attracted the attention of many regulators, even Janet Yellen, US Treasury Secretary. Where she refers to the crash of this stablecoin as a good example of how lack of regulation can a threat to financial stability.
Due to the interconnectedness between many blockchains, either directly or indirectly, different assets suffered devaluations in a market already on a downward trajectory. The biggest consequence was for those investing in UST and Luna, who saw a loss in full, or close to it.
This crash serves as a warning about the dangers of certain financial products with a lot of room to speculate on their value, especially in the world of crypto assets, where there is still a lot of uncertainty about the viability of some projects due to their youth.
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