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Crypto Financial Panic: What went wrong with TerraUSD, the stablecoin that terrified the market?

The failure of the third largest stablecoin is a blow to the confidence of the crypto ecosystem.  REUTERS/Soe Zeya Tun/File Photo
The failure of the third largest stablecoin is a blow to the confidence of the crypto ecosystem. REUTERS/Soe Zeya Tun/File Photo

The collapse of a stablecoin, the instrument created to shield cryptocurrency investors from the enormous volatility of that revolutionary market, brought crypto wave enthusiasts to the brink of collapse. What didn’t have to happen, happened. And, although the ecosystem fought tooth and nail to correct the anomaly, the doubts remained and the confidence in the system will be dented for a long time.

Bitcoin lost half of its historical maximum value, Ether -the currency of the Ethereum protocol- was not far behind in the collapse and other altcoins such as Binance Coin, XRP or Solana also fell in the furious slide that is formed in each bear market crypto. Nothing new, traders and enthusiasts are used to these jolts which they see as the birth pains of a new global financial era. But a much more serious episode has many unable to fall asleep.

Amid the volatility of cryptocurrencies, one of the crypto stablecoins –stablecoins– more successful added to the swings of the market. This is TerraUSD, a stable cryptocurrency that operates under the code UST and is the third largest by market capitalization. one is not supposed to stablecoin shake it off It is supposed to remain, it is worth the obvious, stable.

Not so stable.  TerraUSD, the stablecoin trading as UST, should never have moved away from the $1 price like this.
Not so stable. TerraUSD, the stablecoin trading as UST, should never have moved away from the $1 price like this.

Stablecoins are tokens held by a blockchain, but unlike assets like Bitcoin, their goal is to consistently match the purchasing power of a fiat currency, most often the US dollar. stablecoins they were first created to give traders a tool to quickly move between more volatile positions. In addition, investment offers with sky-high interest rates also attracted other types of public (something that was very important in the unfortunate case of TerraUSD).

TerraUSD, in UST parlance, missed its mark. After a meteoric rise to the top of the major cryptos, it failed to maintain its peg to the dollar. The distance between the value of UST and the dollar was momentary, efforts to straighten it out seem to be paying off now, but confidence in it was severely damaged. This stablecoin can no longer ensure that it is stable.

The value of TerraUSD in the market collapsed to touch 68 cents on the dollar, according to data from CoinmarketCap, a distance of 32 cents from its target. Thought in pennies it seems like a minor problem. But for a crypto stablecoin looking for 1-to-1 with the US dollar it’s a huge thing: it’s a 32% drop.

Put another way, the losses for a total circulation of 18 billion UST was equal to USD 5.76 billion at the time. Nothing that resembles stability.

TerraUSD is not just any stable cryptocurrency. It was the promise of the crypto ecosystem to be able to completely detach itself from the traditional financial system. There is stablecoins older and more popular, by market cap, such as Tether (USDT) and USD Coin (USDC). Terra or UST had reached third place and was on track to gain ground. And this is because it was very different from the previous ones.

Tether and USD Coin achieve parity 1 to 1 with the dollar in the old way: for each token, USD 1 fits. Well, not exactly 100% and not totally with dollars, but a sufficient percentage and with other equally safe assets . Tether has received criticism for the opacity of the reserves with which it supports the circulation of its “crypto dollars”, but it is still there, as the most used (even in the “caves” of Buenos Aires).

The logo of Luna, the cryptocurrency that supports the stablecoin TerraUSD
The logo of Luna, the cryptocurrency that supports the stablecoin TerraUSD

USD Coin, second stablecoin in importance -the other “crypto dollar”-, contracted public external audits to verify that the reserves exist and are correctly managed. That earned him appreciation in the market.

There are many others, but these stablecoins they are imperfect for the crypto dream. They depend on traditional dollars, precisely what they seek to overcome. they are called stablecoins “backed” or collateralized

The ecosystem has been searching for years for a way to make a 100% on-chain stablecointhat is, completely oblivious to the outside world.

UST or TerraUSD were looking to achieve that. What is known as a stablecoin “algorithmic” or “decentralized” because decentralization is its main reason for being. Free of banks, regulation and risk of censorship of transactions.

Under the leadership of Do Kwon, the alma mater Terra and the crypto Luna on which it is based, a mechanism was created that should be able to maintain the price of the stablecoin around USD 1 automatically through arbitrage. How does it work? Anyone who has 1 UST can immediately exchange it for the number of Luna cryptocurrencies that are necessary to obtain a value identical to that of USD 1.

It works as follows: if at any time UST is worth less than USD1, holders of this stablecoin they have incentives to buy them cheap, turn around, and exchange them for the equivalent of $1 worth of Luna. Conversely, if at any point TerraUSD were to trade above $1, the incentives line up for traders buy Luna, change it for the stablecoin and then sell UST for more than $1.

Bitcoin also suffered one of its usual crashes in recent days
Bitcoin also suffered one of its usual crashes in recent days

In times of automated trading, these arbitrages can be completed at the speed of light. Thus, the price of UST or TerraUSD stayed cents above and below USD 1 for a long time, never moving away. An automatic stabilization mechanism, driven by supply and demand.

The protocol was a furor. More and more users demanded this digital dollar totally disconnected from banks, governments and the international financial system. Luna, the token that supports TerraUSD, went from $10 to $100 in market value. The crypto dream come true: money for nothing.

The problem with this type of arbitrage stabilization is that it works well in calm times. And in the crypto world, calm times are not very long. And the obvious risks.

“You have a two-token system and one of them has no intrinsic value, it’s just derived from secondary trade value, and the other token is supposed to be a stable token, and you have arbitration,” explained Ryan Clements, associate professor of law. Entrepreneurship at the University of Calgary at CoinDesk.

“At some point you look at the one that has no intrinsic value and think, why is it worth $5?” he added.

After the latest rate hike in the US, the last hike of the Fed, all the markets of the world went into convulsion. Wall Street fell to its lowest values ​​in a year, energy stocks tumbled, emerging markets fell. All risk assets went into decline and the riskiest of all, cryptocurrencies, fell even more.

In this context Luna, the crypto that supported TerraUSD, also fell into the slide. This afternoon it was worth USD 30.81. It loses 44.01% in 24 hours and 63.93% in the last 7 days, according to data from CoinMarketCap.

Now suppose for a moment that the value of all Luna tokens in circulation fell below the value of all Moon tokens in circulation. stablecoins TerraUSD or UST, whatever you prefer to call it, and there aren’t enough of them to hold 1 to 1. In reality, TerraUSD’s backing isn’t just Luna. Also with Bitcoin and other cryptocurrencies, to make it more secure. But they all go down hard these days.

“There was a very large and very fast exit from UST, but apart from that the entire market fell, and since a lot of the reserves were Bitcoin, which also fell, that raised the question of whether they could sustain the parity,” he explained. Manuel Calderon, professor at the Torcuato Di Tella University specialized in cryptocurrencies. “It’s how its design works, it’s designed so that when the demand changes, the price takes off from 1, and then due to arbitrations it comes back, and it had happened last January that it took off for a few hours and came back, but this time it was much stronger” he explained.

A crypto exchange run was created. The Moons are not enough to pay for the UST in circulation. At least not a dollar each. The stabilization mechanism did not play in favor either. The incentive to buy cheap and sell for Luna failed to hold up amid the crypto crash.

Mistrust further accelerated the collapse. Luna Foundation Guard, the organization behind the protocol, came out to combat the decline with sales of Bitcoin and other reserves. And managed to return to the value of the stablecoin at just over 90 cents on the dollar. But the damage is done.

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