Terra LUNA's Collapse Has Shaken the Crypto Sector: Here’s What Happened

Jason Mountford
Jason Mountford
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June 23, 2022
· 5 min read
Terra Luna’s Collapse Has Shaken the Crypto Sector: Here’s What Happened
Terra LUNA's Collapse Has Shaken the Crypto Sector: Here’s What Happened

Whether you’re into crypto or not, you’ve probably seen something about the collapse of Terra Luna (LUNA). Cryptocurrency is a notoriously volatile, unregulated and sometimes shady asset class, and this is the latest example of the risks that investors take in this space.

If you’ve not followed this story or seen anything about it yet, the best place to start is to have a quick look at the price chart.

Terra Luna’s Collapse Has Shaken the Crypto Sector: Here’s What Happened
Source: CoinMarketCap May 2022

It’s pretty crazy, and even a glance will have you asking - what happened to Terra LUNA? I’m going to be answering that question in today’s article. This won’t be a deep dive into the algorithmic complexities of LUNA, but rather a broad overview of how it was set up and why it crashed.

How Does Terra LUNA Work?

Okay, I’m going to be honest. It’s pretty complicated. Firstly, Terra and LUNA are actually different things. Terra is the name of the blockchain, and LUNA is a token that has been created on the blockchain to help make it work. Think of it kind of like your VISA or Mastercard. The VISA or Mastercard network is what keeps a record of all of the transactions around the world (like the blockchain), and the GBP in your bank account is money that you can use on the network (like the token).

With me so far? Okay, so, as well as LUNA, Terra also creates stablecoins, which are designed to remain equivalent to a regular currency like GBP or USD. One of the stablecoins on the Terra blockchain is TerraUSD. Usually, stablecoins are kept stable by holding an equivalent amount of the actual currency in reserve, but TerraUSD doesn’t work this way. TerraUSD is bought using LUNA, and it aims to keep the price of TerraUSD pegged to the actual US dollar by an algorithm designed to create and destroy the supply of LUNA. We’ve got a more detailed rundown on how it works here.

Why Did Terra LUNA Fail?

Basically, the algorithm didn’t work. The demand for TerraUSD has been heavily propped up by its use for staking on the DeFi protocol, Anchor. This was offering interest of up to 20% for investors who parked TerraUSD there, and almost 75% of the entire supply was held on the Anchor protocol. The sustainability of these returns has been a source of controversy, with parallels being drawn to companies like Uber, who have spent millions buying up market share whilst racking up huge losses. 

Over the course of a few days, these deposits with Anchor fell from US$14 billion down to US$3 billion. This huge withdrawal of liquidity from the system caused panic in the market, and the LUNA algorithm struggled to keep pace with the rapidly dropping price of TerraUSD. Terra scrambled to try and shore up the value of the blockchain, with extra security added in the form of loans and even Bitcoin reserves, but ultimately it was not enough to stop the selling pressure.

As of the time of writing, TerraUSD has fallen to less than US$0.10, and LUNA has crashed from a high of over US$116 in early April to US$0.0001. Even worse, the Terra blockchain was halted for a number of days, locking remaining investors into their positions.

This is a complete and utter collapse, and there have been billions lost by everyone from small investors to large institutions. Binance, one of the world’s largest crypto exchanges, held US$1.6 billion in LUNA, which is now worth less than US$3,000.

The question now raised is whether this was a natural reaction to an imbalanced market, like the 2008 credit crisis, or whether this was a concerted attack on the system by big behind-the-scenes players. Such a large swing out of Anchor does seem suspicious, and even Paulo Ardoino, Chief Technology Officer at Tether has suggested that this was a coordinated strike on Terra. Whether this is true or not will surely come to light in time.

What Does Terra LUNA’s Collapse Mean for Crypto Investors?

This is another example of the risks of investing heavily in cryptocurrency. The blockchains and assets that are being created on a daily basis are, by and large, new and untested. There are likely to be some cryptocurrency projects that end up having staying power and becoming a part of mainstream life, but we are still a long way off this level of stability.

If you want to invest in cryptocurrency, just do it knowing that you could lose everything you put in. This is true for newer coins and tokens like LUNA but also for the old guard such as Bitcoin and Ethereum. That’s not to say you shouldn’t invest if you want to, but you should be comfortable with the risk you’re taking and understand how a permanent loss could impact your finances.

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Jason Mountford
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Jason Mountford

Jason is a qualified Financial Adviser in both the UK and Australia and holds a Master’s Degree in Applied Finance. He loves to write about investing and personal finance, and in his spare time, you’ll find him training for marathons and spending time with his family.
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