Why Did Cryptocurrencies TerraUSD and Luna Unravel? Stablecoin Price Crash Explained

A variety of cryptocurrencies touted for their purported stability have come under close scrutiny as regulators, individual investors, and veteran digital asset traders alike Follow a spiral from the rate of 1 dollar to its coin.

The recent drop of TerraUSD and its sister stablecoin Luna has left investors with billions of dollars in losses and a return to other cryptocurrencies. Their plunge has raised urgent questions about the regulation of digital assets and undermined claims by crypto developers that they can create a new form of finance untouched. affected by the destabilizing banking practices that sometimes occur in traditional finance.

Here’s what you need to know about stablecoins and what happened:

What is a stablecoin?

Cryptocurrencies like bitcoin are volatile digital assets and tend to have large fluctuations that sometimes happen within seconds. Just a tweet or comment from Tesla CEO Elon Musk can set them in motion.

Stablecoins are supposed to eliminate that volatility. Through different designs, their value is tied to the value of government-issued currencies such as the US dollar. In theory, one stablecoin is equivalent to one dollar, regardless of which way other cryptocurrencies are moving.

These coins have become a larger part of the crypto ecosystem over the past two years, with professional traders and individual investors alike having accumulated around $180 billion of that. until mid-May.

Why did they become so popular?

Traders prefer to buy currencies like bitcoin, ether, and dogecoin using digital assets pegged to the dollar because when they buy or sell, only the price of the crypto asset changes.

Stablecoins also allow for fast transactions with no settlement time associated with government-issued currency, which can take several days. If someone wants to sell bitcoin and quickly lock in profits with their dollar, they can buy a stablecoin instantly on major crypto exchanges.

How does a stablecoin work?

There are two main types of stablecoins: asset-backed and algorithm-backed.

The most popular stablecoins, like tether and USD Coin, maintain their level with the asset. USD Coin-backed assets include only cash and short-term US government securities, according to its issuer.

Tether Holdings Ltd. — the largest issuer of stablecoins by market value, tether — says its value is backed by both safe-haven investments, such as cash and short-term US government securities, and those riskier stuff, including short-term IOUs known as paper trades, secured loans to companies, and other cryptocurrencies.

So-called algorithmic stablecoins are not backed by assets, instead using financial engineering to maintain their link to the dollar.

Previously, the TerraUSD algorithmic stablecoin maintained a $1 price by relying on traders to perform the arbitrage function between the values ​​of Terra and Luna. When Terra falls below the peg, traders “burn” the stablecoin – removing it from circulation – by exchanging TerraUSD for $1 worth of new Luna units. That action reduced the supply of TerraUSD and increased its price.

Conversely, when the value of TerraUSD rises above $1, traders can burn Luna and create new TerraUSD, thereby increasing the stablecoin supply and reducing its price back to $1.

Do Kwon, a Korean developer, created TerraUSD. The coin launched in 2020 and before the crash had grown to more than 18 billion dollars.

What caused TerraUSD to break out of its peg?

Traders said the catalyst for the drop – which started over the weekend of May 7-8 and snowfall the following Monday, May 9 – was a flurry of large withdrawals from Anchor Protocol, a cryptocurrency bank created by developers at Mr. Kwon’s company. , Terraform Lab.

Such platforms are used by cryptocurrency investors to earn interest on their coins by lending.

At the beginning of May, investors deposited more than $14 billion in TerraUSD into Anchor, according to the platform’s website. The majority of the stablecoin supply has been used in the Anchor platform. The big deals of that late May knocked TerraUSD off its $1 value. The instability prompted many investors to withdraw their TerraUSD from Anchor and sell the coin.

That resulted in more investors pulling out of Anchor, creating a stratification effect of more withdrawals and more selling. TerraUSD deposits at Anchor fell to about $1.6 billion on May 13, Anchor’s website says.

What does this mean for other cryptocurrencies?

A reserve fund of about $3 billion in bitcoin and other crypto-resources, owned by the Luna Foundation Guard, a nonprofit co-founded by Mr. Kwon, has been largely depleted amid efforts to urgent to maintain the peg for TerraUSD in mid-May, according to the fund’s data dashboard. The fund’s sale of large amounts of bitcoin contributed to the sharp drop in bitcoin’s price earlier this week, analysts and traders said.

As TerraUSD and Luna began to drop during the sell-off week, bitcoin also dropped, falling below $26,000 on Thursday, May 12.

What happens next?

Mr. Kwon tried to rally his followers after the sell-off of TerraUSD and Luna. The blockchain, a digital ledger of transactions that underpins both coins has been halted twice as its network validators seek to stabilize digital assets.

But both TerraUSD and Luna have plummeted from their former values. Many traders have sold in the hope that the asset will not be able to recover back to its original levels. And even crypto enthusiasts say this has shaken their faith.

It could also open up stablecoin-focused legislation. When TerraUSD broke away from the peg on May 10, Treasury Secretary Janet Yellen went on to call on Congress to authorize stablecoin regulation. Yellen said the current law does not provide comprehensive standards for new properties.

Write to Caitlin Ostroff at caitlin.ostroff@wsj.com

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https://www.wsj.com/articles/why-did-cryptocurrencies-terrausd-and-luna-unravel-stablecoin-price-crash-explained-11652462779?mod=rss_markets_main Why Did Cryptocurrencies TerraUSD and Luna Unravel? Stablecoin Price Crash Explained

Edmund DeMarche

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