Why are TerraUSD and Luna Cryptocurrencies unraveling? Stablecoin Price Crash Explained

A wide range of cryptocurrencies touted for their purported stability have come under close scrutiny as regulators, individual investors and veteran digital asset traders follow suit. track a spiral from a $1 peg to a coin.

The recent collapse of TerraUSD and its sister stablecoin Luna investors suffer losses of billions of dollars and back 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. One only tweet or comment from Tesla CEO

Elon Musk

can cause them to move violently.

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. – largest stablecoin issuer by market value, tether – says its value is backed by both safe investmentsuch as cash and short-term U.S. government securities, and riskier peopleThese include short-term IOUs known as commercial paper, 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.

The markets have been looking increasingly shaky lately: Stocks, bonds, and cryptocurrencies are all falling as investors struggle to manage volatile global financial markets. WSJ’s Caitlin McCabe looks at some of the reasons behind the recent market frenzy. Photo: Spencer Platt / Getty Images

What caused TerraUSD to break out of its peg?

Traders say the catalyst for the drop – which begins the weekend of May 7-8 and snowfalls the following Monday, May 9 – is a series of large withdrawals from Anchor Protocola type of cryptocurrency bank created by developers at Mr. Kwon’s company Terraform Labs.

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 is 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. Anchor’s website says TerraUSD deposits at Anchor have dropped to around $1.6 billion as of May 13.

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 TerraUSD peg in mid-May, according to the fund’s data sheet. 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 started to decline during the sell-off week, bitcoin also fellbelow $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 decoupled from the exchange rate on May 10, Treasury Secretary Janet Yellen continued to call on Congress to allow stablecoin regulation. Yellen said the current law does not provide comprehensive standards for new properties.

Write to Caitlin Ostroff at [email protected]

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