What happened? The Terra debacle exposes vulnerabilities plaguing the crypto 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 turbulence is due in large part to the real-time decay of Terra, a 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 collapse, Terra’s other related 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 .

The Terra ecosystem explained

As highlighted above, the Terra Protocol is powered by the use of two core tokens, namely UST and LUNA. Network participants gain the ability to imprint UST by burning LUNA on the Terra Station’s portal. Simply put, the Terra economy can be thought of as one that consists primarily of two pools: ie one for TerraUSD and one for LUNA.

To preserve the value of UST, the LUNA supply pool either adds to 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 fiat assets.

To better illustrate how UST (or algorithmic stablecoins in general) works, it would be best to use a simple illustration. For example, let’s say the value of UST is $1.01, then users will be encouraged to use Terra’s swap module to exchange $1.00 worth of LUNA for 1 UST, giving them a Net profit of $0.01.

Now, when the tables are turned and UST drops to $0.99, network users can do the exact opposite, leading to the protocol prohibiting some users from trading $1.00 worth of UST against 1.00 LUNA redeem $. This once hypothetical scenario is now a living reality, not only leading to the disintegration of the Terra Protocol, but also smearing the crypto industry’s reputation in the eyes of investors around the world.

Damage control, but to no avail

Once LUNA and UST went into freefall earlier this week, so did the protocol’s co-founder, Do Kwon released a series of tweets announcing corrective measures to curb further bleeding. As a preliminary step to counter the decoupling of UST from the dollar, Kwon strengthened burning UST, which we now know in hindsight didn’t work.

Kwon claimed that increasing the base pool from 50 million to 100 million Special Drawing Rights (SDR) and reducing the PoolRecoveryBlock from 36 to 18 could potentially increase the minting capacity of the protocol from $293 million to a whopping $1.2 trillion could.

Simply put, by introducing the above changes, the Terra team has been given the ability to mint four times more UST from scratch, a process now jokingly referred to as Kwontative Easing. Jack Tao, CEO of cryptocurrency exchange Phemex, provided an expert opinion on the matter, telling Cointelegraph that looking back, the doom signals surrounding UST and LUNA have been there for quite some time.

First of all, he believes that the general idea surrounding algorithmic stablecoins is inherently pretty tenuous, as these offerings lack any sort of actual collateral assets. 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’s reserves. In this regard, Tao added:

“These purchases created an oversupply of UST that quickly began to decline as selling pressure on LUNA and subsequently UST began to mount. Once this sale took place, the Luna Foundation Guard had to swap out their bitcoin to maintain the bond. But the knee-jerk selling pressure continued and all the assets involved began falling sharply.”

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Tao added that the Anchor Protocol — a savings, credit, and lending 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 have 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 borrowings fell by over $1 billion. As a result, the broader ecosystem has now been plagued by trust issues, particularly when it comes to stablecoins.”

Terra officially goes offline after the collapse, albeit briefly

On May 12th, Validators collectively serve the Terra Network decided Halting 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 had been halted at block height 7,603,700. With LUNA’s value down nearly 100%, the company’s spokesperson hinted that developers are no longer confident in their ability to prevent third-party governance hacks. The downtime was short-lived, however, as Terra’s core team announced that it would resume operations once validators were able to apply a patch that disables all further delegation.

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

Bad prospects for the entire industry

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

“Unfortunately, the LUNA situation will leave a bad taste in everyone’s mouth as it has caused many great altcoins to plummet in value. A more important aspect of this development, however, is its timing. All of this happened at a time when war is raging in Eastern Europe, supply chains are being restricted worldwide, inflation and interest rates are rising.”

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However, he acknowledged that all of this could have a small silver lining: the event could result in only the best projects surviving, with most sketchy platforms losing investor interest in a big way. “There will be much more scrutiny from now on, and investors will feel comfortable choosing to only invest in the biggest cryptos like Bitcoin, Ether and Solana,” he said.

Therefore, it will be interesting to see how this story unfolds further and what impact this incident has on the development/development of the cryptocurrency market as a whole, especially as the traditional financial system also continues to be plagued by a growing amount of negative financial pressures.