The Terra-Luna Crash Explained In Layman's Terms

It's been over a year since one of the largest crashes in any financial market happened: the collapse of the Terra (LUNA) and TerraUSD (UST) coins. We sometimes use the word 'crash' casually, even when certain markets didn't lose their entire value.

But, it's a different beast with Terra; its price went to virtually zero from a pretty high point. The causes of the multi-billion decline are public knowledge. But, as with many things in crypto, it may be too complex for the average Joe to grasp.

This article will explain the infamous Luna crash in the simplest way possible for 'noobs' or those needing a refresher.

Understanding the two main coins involved

The Terra-Luna crash involved two related digital currencies created by Terraform Labs. This was a blockchain company founded by two South Korean entrepreneurs, Do Kwon and Daniel Shin.

Their main products are a stablecoin and a regular cryptocurrency that supports it. A stablecoin is a digital currency with a 'stable' value, often $1 (or other equivalent). The purpose is to have a coin investors can use for digital transactions or keep their money in without fluctuating value.

The rule with all stablecoins is that another asset should back it, usually a currency like the US dollar. This means that the company issuing the token must have that asset in reserve.

As strange as it sounds, some stablecoins don't need to be backed by anything (algorithmic stablecoins). The algorithm's primary purpose is always to keep the 1:1 peg.

It is meant to ensure the supply doesn't become too much that it deflates or that too much demand doesn't over-inflate the coin's value. Consider LUNA the 'shock absorber' for the UST price.

Users could always trade a dollar's worth of LUNA for UST (and vice versa) to pocket a small profit: arbitrage.

If UST traded at $1.03, you could 'burn' $1 of LUNA to 'mint' $1 of UST. By selling, this would result in a 3 cents profit difference (1.03–1)

Conversely, if UST was trading at 97 cents, you could buy $1 of UST for 97 cents and trade that $1 for LUNA. This would give you 3 cents in profit (1.00–97 cents).

As complex (and even ridiculous) as it sounds, the system worked until it didn't.

How the crash happened

A major element of this whole conundrum was the Anchor Protocol. Many stablecoins offer above-average returns for 'staking.'

Anchor promised a 20% max yearly yield, a big draw for people to get involved in the LUNA-UST ecosystem. The cherry on top was that LUNA, on its own, was in the top 10 of traded coins. It reached $119 at one point and was one of Bitcoin's competitors.

Still, the unanswered question was where Terra got the money to pay the interest to investors (or the 'Lunatics'). Remember, no reserves or collateral were backing UST. Only the demand for LUNA was keeping the system in place.

A few days before the crash on 07 May 2022, roughly $2 billion worth of UST was taken off Anchor. The reason for this is still debated today, but many believe it was a malicious attack.

Nonetheless, this event drove UST's price to 91 cents from $1. The so-called 'burn and mint equilibrium' collapsed due to how many people were trying to get UST back to $1.

We already mentioned that there was an incentive to arbitrage the system. People were trying to exchange 91 cents of UST for $1 of LUNA and sell it to get the 'quick buck' they got before. Only this time, it didn't work because:

• It resulted in an oversupply of LUNA (making the coin less valuable)
• Many people were selling LUNA at the same time for the small arbitrage gains

Everything went into panic mode quickly as traders lost money in the arbitrage when LUNA got less valuable. Meanwhile, others were selling their UST directly for ordinary dollars.

This resulted in both coins crashing to 'zero point nought, nought, nought, nought…'

The aftermath

As expected, disgruntled investors pointed fingers at Terraform Labs, particularly the head honcho Do Kwon. His partner had left the company a few years before. Terraform Labs received several class action lawsuits, especially in South Korea and America.

Meanwhile, Do Kwon and those in his company also got arrest warrants in the months after the crash.

After much ducking and diving, Do Kwon was arrested in Montenegro while fleeing to Dubai. What's more, they found him with falsified Costa Rican and Belgian identity documents.

Meanwhile, the LUNA community revived the project at the end of May 2022 with a new blockchain and token: Terra 2.0. Only time will tell how this comeback will perform in the future.

The main takeaway is that crypto will always remain the Wild West of money-making. So, don't let your guard down!!