In May 2022, LUNA saw one of the most disastrous price crashes in the history of the cryptocurrency market. The price of LUNA, which hit an all-time high of $116 on April 6, was as low as $0.00008 by June 6.
The LUNA crash caused billions of dollars of losses for investors, leaving many to wonder what happened to LUNA. How could the Terra and Luna ecosystem, which was valued at upwards of $60 billion at one point, evaporate within just a few days?
In essence, the main reason for the crash was the hyperinflation in the supply of LUNA triggered by a bank run on UST, the ecosystem’s largest algorithmic stablecoin.
In this article, we will be taking a look at what happened to the LUNA crypto during the crash, as well as the aftermath of the collapse of the Terra and Luna ecosystem. We will, of course, also cover the UST stablecoin, which was the main driver of LUNA’s growth but ultimately also led to its demise.
The history of Terra Network and Luna
The beginnings of the Terra blockchain project date back to 2018, when it was created by a company called Terraform Labs. Terraform Labs was founded by Do Kwon and Daniel Shin. Kwon later gained a lot of popularity and essentially became the public face of the Terra project.
The idea behind the Terra blockchain was to facilitate a decentralized payment system that utilized stablecoins pegged to various fiat currencies. For example, the ecosystem had a US dollar-pegged stablecoin called UST, and a Korean won-pegged stablecoin called KRW. The native token for paying fees on the blockchain was LUNA, which also played a crucial role in maintaining the price of the Terra stablecoins.
Most stablecoins, including USDT and USDC, are backed by reserves of actual fiat money and related assets such as treasury bonds. Terra took a different approach and utilized an algorithmic model in which stablecoins like UST and KRW were pegged through algorithmic means.
Here’s a quick explanation of how the Terra platform worked based on the example of UST, a stablecoin that was designed to be traded as close to $1 as possible. The Terra platform had a mechanism that allowed users to burn $1 worth of LUNA tokens to mint 1 UST. On the other side of the equation, users could burn 1 UST to mint $1 worth of LUNA.
If UST was valued at more than $1, users were incentivized to burn LUNA to mint UST. Then, they could sell the UST for a profit. If UST was valued at less than $1, users were incentivized to burn their UST to mint LUNA, as they would receive LUNA at an exchange rate of 1 UST for $1 worth of LUNA. For about a year and a half, this mechanism regulated the supply of UST according to demand and allowed the stablecoin to maintain its peg. However, it failed catastrophically in May 2022 when the price of UST deviated below its $1 peg significantly.
Luna and UST’s ascent to popularity
For the entirety of 2020, the LUNA market cap stayed below $500 million. The project was seeing some adoption and development, but there wasn’t serious hype behind it yet. LUNA then saw a big rally in the first half of 2021, reaching a market cap of $8.5 billion by March. The second half of 2021 was when LUNA really took off, reaching new all-time highs in a rally that culminated in April 2022 at a market capitalization of $41 billion.
Anchor’s TVL grew at an unstainable pace before the depeg. Image source: DefiLlama
The main driver of the popularity of the Terra ecosystem and the LUNA token was Anchor Protocol, a money market protocol that offered very high yields on UST stablecoin deposits. At times, users were earning APYs of around 20% on their UST deposits.
Since UST was a stablecoin, many users felt that Anchor Protocol was a safe option for earning yield. While the 20% APY seems outrageous now, the crypto market was in an extremely bullish phase at the time, and there was plenty of optimism and exuberance among traders.
The popularity of Anchor Protocol led to a huge increase in demand for UST, causing more UST to be minted. At the peak, there was about $18.7 billion worth of UST in circulation. However, while there was a lot of demand for lending UST on the Anchor Protocol, the protocol didn’t see nearly as much demand for UST borrowing.
Since there wasn’t enough borrowing demand to pay the advertised 20% yield, the Anchor Protocol had to be subsidized. In order to continue paying the 20% yield to UST lenders on Anchor Protocol, $450 million was injected into the protocol’s reserves by the Luna Foundation Guard, an organization founded and led by Do Kwon.
Signs of trouble in the Terra ecosystem
While there were concerns about the sustainability of Anchor Protocol’s advertised 20 APY%, many users thought the worst-case scenario was that the yield would simply be reduced to more sustainable levels. Not many people envisioned a scenario in which both UST and LUNA themselves became almost worthless, which is precisely what happened in May 2022.
As it turned out, UST and LUNA grew too large for their own good, which exposed the inherent flaws in the algorithmic mechanism that was supposed to keep the price of UST and other Terra stablecoins close to their pegs.
It seems that key players in the Terra ecosystem, including Terraform Labs founder Do Kwon, had a hunch that the algorithmic mechanism by itself wouldn’t be enough to maintain the stability of UST. In February 2022, about three months before the collapse of the Terra ecosystem, the Luna Foundation Guard announced a UST Reserve that would hold various assets, including Bitcoin. This reserve would be used to defend the UST peg in the event that it came under significant pressure. Even though the reserve eventually grew to about $3.5 billion, it wasn’t enough to save UST from a total collapse.
Why did LUNA crash? The UST de-pegging and the collapse of Terra
On May 9, 2022, UST began to slip from its $1 peg, falling as low as $0.67 by May 10. Throughout the course of the day, the UST price recovered and stabilized around the $0.90 mark. This was only a temporary relief, as UST began slipping lower again and dropped all the way to $0.23 by May 11.
Luna Foundation Guard, a non-profit organization tasked with supporting the Terra ecosystem, began deploying the UST Reserve to defend the UST peg, but their efforts failed.
Deploying more capital – steady lads
— Do Kwon ? (@stablekwon) May 9, 2022
At this point, the market’s confidence in UST was already damaged beyond repair, and UST holders began rushing for the exits. UST holders who weren’t willing to sell their stablecoins on the open market at a steep discount used the Terra protocol’s arbitrage mechanism to burn their UST and mint LUNA tokens in an attempt to get a better deal.
As we’ve mentioned before, the arbitrage mechanism would issue users $1 worth of LUNA for each UST token they burned. As the price of UST dropped, a growing number of LUNA had to be issued for each UST that users burned. This resulted in a flood of new LUNA tokens entering the market, and the demand for buying LUNA was extremely small as most investors were simply looking to escape from the Terra ecosystem as quickly as possible.
The circulating supply of LUNA grew from 380 million tokens on May 10 to 6.5 trillion tokens by May 13.
LUNA’s supply exploded following UST’s price slipping below the $1 peg. Image source: Messari
The hyperinflation of the LUNA supply, combined with the enormous selling pressure, caused LUNA to experience one of the worst, if not the worst crash in the history of the crypto markets. Those who held on to their LUNA were left with practically nothing.
LUNA was trading at around $62 on May 9, 2022, the day when UST started losing its peg. By May 13, LUNA was trading at around $0.0003 – a drop of more than 99.99%.
The aftermath of the LUNA and UST crash
Even though it’s now clear that UST’s design was unsustainable, it’s unclear what precisely was the straw that broke the camel’s back. A popular theory in the crypto community is that a sophisticated trader or group of traders identified that Terra’s algorithmic stablecoin design was more fragile than the market expected, and began short-selling UST in order to put the $1 peg under pressure and trigger a collapse.
In the aftermath of the Terra collapse, Do Kwon has become a pariah in the cryptocurrency community. South Korean authorities have issued a warrant for his arrest, which also prompted a red notice from Interpol. He was arrested in March 2023 in Montenegro and charged with securities fraud, commodities fraud, wire fraud, and conspiracy.
Meanwhile, the crypto community is still debating whether the Terra ecosystem was intentionally designed as a Ponzi scheme and fraud or if it was simply a poorly designed system that was bound to crash, even if there was no foul play involved.
The collapse of Terra had a disastrous effect on the cryptocurrency industry. The loss of confidence and market turmoil exposed the poor risk management practices of many cryptocurrency companies, which apparently became complacent during the 2021 crypto bull market.
It led to the bankruptcy of Three Arrows Capital, a major crypto hedge fund that was heavily invested in the Terra ecosystem. The aftermath of the Terra collapse also resulted in the bankruptcy of several other crypto lenders, most notably Celsius and Voyager. Still, the community and a decent share of developers rallied around the currency and broader ecosystem in a big way. In fact, LUNC can easily be classified among the most active crypto projects under 1 cent today.
A new beginning? Terra 2.0 and Terra Classic
After a few days, it became clear that the Terra ecosystem failed and couldn’t be rescued. Eventually, Do Kwon proposed to start a new Terra blockchain that would abandon the algorithmic stablecoin functionality and instead function as a general-purpose blockchain for smart contracts. This new blockchain kept the LUNA ticker for its native token, which serves a similar function as ETH does on the Ethereum blockchain.
The “old” Terra blockchain was renamed to Terra Classic, keeping the algorithmic stablecoin functionality. Its native asset was renamed to Luna Classic (LUNC), and the UST stablecoin was renamed to USTC. On this blockchain, the supply of LUNC is still hyperinflated, and USTC is nowhere near its $1 peg, as it’s trading at $0.02 at the time of writing. The Terra Classic community decided to implement a burn mechanism in which a share of LUNC involved in any on-chain transaction is automatically burned. The burn fee, also known as the LUNC burn tax, was originally set at 1.2%, then lowered to 0.2%. Since May 2023, the tax is set at 0.5%.
The mechanism was introduced with the goal of gradually reducing the circulating supply of LUNC from its hyperinflated levels. There is a popular meme in the Luna Classic that they’re trying to get the price of LUNC to $1, although it would take a lot of token burning to get there.
The bottom line: The collapse of the Terra Classic ecosystem and its native assets LUNA and UST was one of the worst crashes in crypto history
The collapse of the Terra ecosystem stands out as one of the worst crypto crashes in history. It witnessed the evaporation of $60 billion in just a matter of days, leaving millions of investors with nearly worthless coins. The impact of the crash was further exacerbated by Terra’s significant presence in the crypto industry. As many crypto investment firms had placed their bets on Terra’s success, the crash decimated their portfolios, leaving most of them scrambling to salvage their companies. Some succeeded, while others, such as Voyager and Three Arrows Capital, did not and ultimately filed for bankruptcy.
It could be argued that the aftermath of the Luna crypto collapse contributed to FTX’s downfall as well, as the exchange had various commitments and deals with numerous investors holding positions in Terra. Arguably, Sam Bankman Fried-owned FTX overextended itself by attempting to rescue various crypto lenders, smaller exchanges, and crypto investment firms in the wake of the Terra collapse.
If you’re wondering if the LUNC price will ever recover from this massive crash, you should read our article covering Luna Classic’s chances of recovery.
Source: https://coincodex.com/article/22749/what-happened-to-luna/