The Luna and UST’s recent crash has taken the whole crypto industry by surprise; Luna experienced a 98% drop just overnight after TerraUSD, its correlated stablecoin started de-pegging from the US dollar.
However, some argue that the early signs indicated that things are about to go wrong. Terra’s fall raises the alarm for a broader underlying concern that needs to be addressed properly: algorithmic stablecoins and the lack of clear regulations.
Stablecoins: How Do They Really Work
We know stablecoins as crypto assets that follow the price of a more stable asset, like the US dollar or Gold. In general, a stablecoin should keep its price within a close range of the price of its underlying asset. But how do they actually achieve that?
Some stablecoins, like Tether, use traditional collaterals to keep the price stable. For example, the issuer has to put $1000 in its reserves before creating 1000 dollar-pegged stablecoins. By reviewing the list of reserved funds, users can easily figure out how much of the stablecoin total supply is truly backed by the company.
By applying algorithms and smart contracts, other projects have come up with other methods to keep the price of their coins stable. Instead of using collaterals, algorithmic stablecoins control the price by increasing or decreasing the supply. TerraUSD, the name that seems to appear quite often in the headlines these days, falls under this category.
TerraUSD’s Crash: What Really Happened
By using Luna, Terra tries to keep the price of UST stable. Users can always trade one UST for 1$ worth of Luna. So, when UST is below $1, investors can make a profit by exchanging their USTs for LUNA. Terra burns the UST to mint LUNA, which reduces the supply of UST and causes an increase in its price to reach $1 again.
UST’s crash can be linked back to the Anchor Protocol, a lending platform on the Terra Blockchain that offers a 20% APY on UST deposits. “75% of UST’s entire circulating supply” was locked in Anchor as investors were trying to benefit from this lucrative opportunity.
Recently, investors started to withdraw their USTs from the protocol which caused an increase in the UST supply. The stablecoin lost its peg on Monday completely, making the selling pressure even worse. As a result, TerraUSD and LUNA went through a very sharp crash.
What It Means for The Crypto Space
We can expect to see a more established and restricted framework for stablecoin regulation by the end of the year. After Terra’s fall, Janet Yellen, the secretary of the U.S. Treasury Department, pushed for more regulations, calling the unregulated cryptocurrencies a threat to financial stability.
Proper regulations can play an important role in the mass adoption of crypto assets. Luna’s crash alongside the current bear market has caused many to experience significant distress and loss. A regulated and transparent crypto market can at least bring more protection to all market members.