Why Crypto Cratered: 5 Things You Need To Know

Two lesser-known coins, TerraUSD and its sister currency Luna, collapsed, reminding some of the 2008 financial crash.

Over the last few days, the cryptocurrency world has faced an intense shakeup due to the precipitous drops of a stablecoin called TerraUSD and its sister currency Terra Luna. The crash has rattled the broader crypto market, and other tokens including bitcoin and tether have also struggled. Terra Luna is now almost worthless. In the last week alone, bitcoin dropped about 25%; it's dropped more than 50% in the last six months. Some have compared the crash to the 2008 financial collapse.

Once aggressively bullish crypto investors are panicking. Some have pumped the brakes. Others have been devastated; Reddit on Thursday began offering support and resources to crypto holders discussing suicide in its forums. One person said their friend attempted suicide over the crash. “Do not be alone, this shit is getting serious,” the person wrote.

The crypto market’s nosedive over the past few days illustrates the high stakes that can accompany a nascent financial system, which has largely been left unregulated. But what actually happened? How will this affect the rest of the crypto ecosystem? What the hell is Terra, and why does it have a sister currency called Luna? Here’s what you should know.

What is a stablecoin?

A stablecoin is a cryptocurrency designed to be pegged to another asset, like the US dollar or the euro. They are meant to be less volatile than other cryptocurrencies like bitcoin or ether, which can swing wildly throughout the day.

Stablecoins serve as a link back to the traditional financial system, acting as a currency with a value that many people understand. Investors who want to park their money while staying within the cryptocurrency ecosystem can turn to stablecoins to avoid the ups and downs of the market.

Some popular stablecoins are tether, the stablecoin with the largest market cap, and USD Coin, founded in conjunction with the exchange Coinbase Global. Theoretically, a stablecoin fixed to USD should maintain its value of $1 per token — but that is not at all what happened this week.

What are TerraUSD and Terra Luna?

While some stablecoins, like tether, are supposed to be backed by assets, others rely on complex algorithms to maintain their peg to the US dollar.

TerraUSD is one of these algorithmic stablecoins. It tries to maintain the same value as the US dollar by using a complex seesawing mechanism with a related cryptocurrency, which is called Terra Luna (or just Luna). While 1 TerraUSD is always supposed to be worth exactly $1, the value of Luna can fluctuate. In essence, TerraUSD uses Luna as a counterweight to maintain its dollar peg. Here’s how it works:

You burn, or destroy, TerraUSD to mint, or create, Luna, and vice versa. Burning one TerraUSD always gives you $1 worth of Luna, and burning $1 worth of Luna always gives you one TerraUSD. It’s like a seesaw, where TerraUSD is on one end, and Luna is on the other.

Let’s imagine the value of TerraUSD falls slightly so it is now worth $0.99. Because you can always exchange 1 TerraUSD for $1 worth of Luna, smart people will immediately take the chance to buy something worth $1 for 99 cents, and earn a small profit of 1 cent. So they burn their TerraUSD to mint Luna and earn a profit.

As more and more people holding TerraUSD try to earn that 1 cent of profit by burning it for Luna, the supply of TerraUSD reduces and its price rises until it hits its $1 peg.

Now imagine that so many people are taking advantage of the arbitrage that the price of 1 TerraUSD actually rises to $1.01. Now this means that people who are holding Luna realize that if they burn $1 worth of Luna they can get TerraUSD and make an extra cent in profit. So as more and more people burn their Luna to create TerraUSD, the supply of TerraUSD increases and its price falls until it hits $1.

Let’s be honest: If you are among the vast majority of people who don’t fully grasp the mechanism that we’ve just sketched out, you probably should not be investing in stablecoins.

So what happened to TerraUSD and Terra Luna this week?

Basically, the balancing act between TerraUSD and Luna broke.

The biggest reason that most people held TerraUSD was because of something called the Anchor Protocol. Think of Anchor as a savings account for your TerraUSD, but it pays you 20% interest — which is a really good deal for a savings account.

In past months, it made sense to simply park TerraUSD in an Anchor account and watch the 20% yield come in, especially because there’s not much you can actually use crypto for. Until as recently as last Saturday, 75% of all the TerraUSD in circulation was deposited in Anchor, according to Coindesk.

But in March this year, Anchor passed a resolution to replace the 20% rate with a variable rate. Then over the weekend, large amounts of TerraUSD were withdrawn from Anchor, the Wall Street Journal said, worrying traders and prompting them to sell their TerraUSD and Luna tokens. Another group of investors used a blockchain project called Curve Finance to swap TerraUSD for other stablecoins.

People started heading for the exits by burning TerraUSD in exchange for Luna. The supply of Luna ballooned, causing the price to plummet. In a sense, Luna was pushed off the seesaw.

As more and more people tried to dump their TerraUSD, the balancing mechanism stopped functioning — TerraUSD crashed, and so did Luna. The stablecoin plummeted to $0.14 at one point Friday. Luna has become almost worthless, tanking to less than 1 cent on Friday as well.

Do Kwon, the creator of TerraUSD and Terra Luna, on Wednesday outlined a rescue plan to address the crash. “I understand the last 72 hours have been extremely tough on all of you - know that I am resolved to work with every one of you to weather this crisis, and we will build our way out of this,” he wrote on Twitter.

“Short-term stumbles do not define what you can accomplish,” he said in another tweet. “It’s how you respond that matters.”

What does this mean for other coins?

The cryptocurrency market, like other financial systems, is intricately entwined. As TerraUSD fell, the losses bled into other cryptocurrencies. Tether dropped to $0.96 on Thursday, though it later rebounded to again match the value of the US dollar. As tether slid, bitcoin plunged to around $25,400 on Thursday, its lowest value since December 2020, before rallying to around $29,500 on Friday.

Overall, the entire crypto market has been slashed by more than half since November, falling to $1.2 trillion from $2.9 trillion, according to data from CoinMarketCap.

What’s more, the crash could potentially have an effect on the traditional financial system. As Bloomberg’s Matt Levine points out, some traditional traders own crypto. If their crypto holdings take a dive, it could affect how those traders operate elsewhere.

What effect could all of this have?

First, real people appear to be losing a lot of money. On Reddit, members of the Terra Luna forum have been posting about suicide. “I lost over 450k usd, I cannot pay the bank. I will lose my home soon. I'll become homeless. suicide is the only way out for me,” one member wrote. Other members have been sharing personal stories of past attempted suicide and sharing suicide prevention resources.

"The safety and wellbeing of our users is a top priority for us, and we take active steps to provide support and resources on our platform,” a Reddit spokesperson said in a statement to BuzzFeed News. “In certain situations, we reach out to moderators to offer support and resources for their community, and have done so in this case.”

The episode has also led to more calls for regulation. Testifying ​​before the Senate Banking, Housing and Urban Affairs Committee on Tuesday, Treasury Secretary Janet Yellen mentioned the TerraUSD drop. “I think that simply illustrates that this is a rapidly growing product and that there are risks to financial stability and we need a framework that’s appropriate,” she said.

Meanwhile, the crash has cast doubt on the entire crypto market. And now it’s clear: Not even so-called stablecoins are as stable as they claimed to be.

The US National Suicide Prevention Lifeline is 1-800-273-8255. The Trevor Project, which provides help and suicide-prevention resources for LGBTQ youth, is 1-866-488-7386. Find other international suicide helplines at Befrienders Worldwide (befrienders.org).

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