What this week's Terra stablecoin fiasco means for crypto and what investors can learn from it

Published Thu, May 12 202210:59 AM EDTUpdated Thu, May 12 20222:36 PM EDT

The downfall of the Terra project has investors in a panic this week as they try to understand why its UST stablecoin broke from its $1 peg , down more than 99% at one point. Last week UST had pushed into the top 10 cryptocurrencies by market cap. It lost about 75% of its value Wednesday before slightly recovering. Its sister token, luna , lost about 98% of its value over the past week. The project crashed about as quickly as it grew. Its meteoric growth was in part to do with a sort of cult of personality around Terra's leader, Do Kwon. Part of it was greed; many have said UST's popularity took off when the Anchor Protocol, which also runs on the Terra Blockchain, began promising nearly 20% yields for depositing UST. It all led to huge investor losses in one of the biggest and most high-profile endeavors in crypto. It also happened around the time the group behind it, the Luna Foundation Guard, began a highly publicized operation to bulk up its bitcoin reserves to protect its peg. "Purely algorithmic stable coins are dead forever," said Omid Malekan, a crypto industry veteran and adjunct professor at Columbia Business School. "This thing is so big and so catastrophic, you do need a certain amount of faith on the part of the stablecoin holder for the project to have a chance." It's unclear what the best course of action for investors is going forward. And there are many unanswered questions about why the UST lost its peg in the first place. But UST's move isn't the first depegging in stablecoins and it probably won't be the last. Here's what you need to know about the fiasco that unfolded this week. What happens now for investors? In theory, UST could find its peg again and investors might be able to sell their holdings at $1. Depegged stablecoins in the past have repegged. But because of the mechanism by which UST and its sister token luna function to stabilize the peg, it isn't likely. "Other people would have to keep buying UST to convert to luna, and then sell their luna to come back and do this trade again – which just means that the price of luna gets pounded down to a point that the whole thing completely collapses," said Malekan. The system is complex, but basically, unlike centralized stablecoins that are backed by assets, these kinds of stablecoins maintain their pegs through algorithms that encourage traders to take advantage of price changes. At least last week, minting one new UST required "burning" or destroying one luna, and vice versa. This structure allowed for arbitrage opportunities that were key to maintaining the peg; users could always swap one luna for UST and vice versa at a guaranteed price of $1, regardless of the market price of either token at the time. And if the price of luna, the governance token of the Terra blockchain, falls too low, the blockchain becomes vulnerable to attacks and its security framework falls apart. In crypto, financial incentives on the blockchain are what ensure the security of a decentralized network. "For the USD to repeg it might mean that the price of luna needs to be falling, falling, falling but at a certain point that blockchain becomes unsecure," Malekan said. "You don't want to have a stable coin on an unsecured blockchain." Michael Rinko, venture associate at AscendEx, noted that in the past, algorithmic stablecoins that have depegged have found their peg again, but the secondary coins associated with them – which in this case would be luna – have died. "Best course of action is to try and redeem UST for luna and get out at whatever price you can," Rinko said. "It looks like luna is going to zero so unless some seriously deep-pocketed investors step in to publicly back luna, the project will likely die." Early Thursday morning, Terra tweeted that it's proposing to burn the remainder of its UST holdings as an "emergency action" and said decreasing UST while increasing the available luna is the easiest way to repeg. The future of stablecoins A decentralized algorithmic stablecoin hasn't worked in the past, and Terra gave many in crypto a lot of hope that this one would take off. Clara Medalie, head of research at crypto data provider Kaiko, said it was "a decent idea" to cushion a possible depegging by having multiple assets in reserves. "But once it came down to it, like we've seen over the past week, it created immense selling pressure for bitcoin and for any cryptocurrency that was in that reserve," she added. Terra hasn't done other projects any favors on the regulatory front; stablecoins have been top of mind for regulators for months now for the exact reasons highlighted by the Terra fiasco: transparency in the trading of stablecoins, the reserves backing them and how much market participants rely on them to enable trading in other crypto protocols. On Wednesday, U.S. Treasury Secretary Janet Yellen pushed for stablecoin regulation, again, to be passed by the end of the year, and cited Terra. "A lot of stablecoins have launched with the same type of pegging mechanism.… Now that this model has proved ineffective – it was unable to stop a collapse in the depegging of a stable coin – it's very uncertain the futures of these other algorithmic stable coins that rely on similar mechanisms for pegging the price to one U.S. dollar," said Medalie. Contrary to how Terra makes crypto look on the outside, there are many well-meaning builders in the industry committed to open-source principles who will want to clean up and even get more strict on how they self-regulate. "The ecosystem will police itself now even more so and say, 'look, this system can be gamed, we realize now that there are bigger players and we're not going to let someone create this again, or we're not going to allow billions of dollars to flow into it,'" Adam Blumberg, co-founder of Interaxis, a crypto education and training company for financial advisors and investors. "We're going to call it out next time."

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The downfall of the Terra project has investors in a panic this week as they try to understand why its UST stablecoin broke from its $1 peg, down more than 99% at one point.