Why prices of TerraUSD and LUNA stablecoins crashed

In a setback to cryptocurrency traders, the value of all major cryptocurrencies has fallen sharply creating a market-wide crash. Bitcoin has fallen by 15.8%, Ethereum by 23.02%, and Solana by 36.7% in the last 7 days as of 11 am today, according to Coinmaketcap.

However, the most alarming drop has been seen with TerraUSD (UST), a stablecoin, which has seen its value drop by 82.19% to $0.6. Its sister coin LUNA saw its price drop by 99% from $120 to $0.02.

Crypto exchanges including Binance have delisted the $LUNA token. “The Terra blockchain has officially halted at block 7607789. Terra Validators have halted the network to come up with a plan to reconstitute it. More updates to come," Terra said in a Twitter post.

Ashish Singhal, co-founder & chief executive of CoinSwitch, attributes the crash in value across cryptos to several factors.

"The current market behaviour is a combination of several developments: High inflation, US Fed interest rate hike, broader capital outflow from asset classes, Ukraine war, dark clouds over algorithmic stablecoins," Singhal said in a Twitter post.

However, there is more to the crash of value of stablecoins.

Both LUNA and UST are based on the Terra network. Unlike Bitcoin and Ethereum, stablecoins were created to bypass the issue of price volatility associated with most cryptocurrencies. In comparison to them, stablecoins are less vulnerable to market value fluctuations. This is why this crash in the price of UST and LUNA is so surprising. What makes stablecoins stable is that they are linked to some fiat currencies like the US dollar or a commodity like gold or even oil to derive their value.

Traditional stablecoins keep a reserve of a fiat currency they are linked to as collateral assuring the stablecoin's value. The other method used to keep the value stable is by controlling its supply through an algorithm. These stablecoins are called algorithmic stablecoins. UST belongs to the first category of stablecoins while LUNA is an algorithmic stablecoin.

Since the two are interlinked and based on the same Terra blockchain, when a UST’s value falls below $1, traders are given incentives to exchange 1 UST with LUNA worth the same value. Then the UST is burned to reduce the supply and stabilize its value back to $1. Burning a cryptocurrency means pulling them out of circulation.

However, the algorithm couldn't save the stablecoins and the value of UST fell below $1 due to selling on a large scale. Due to the shorting of LUNA across exchanges, the supply of UST increased. Shorting is a tactic used by traders to derive more profit by selling cryptocurrencies to short the value and then buy them back at a lower price.

According to industry experts, the crash was triggered by the Anchor protocol, which allows traders to deposit UST and get up to 20% returns. Early this week, Anchor announced that traders will get 18% returns on deposits, and many decided to sell their UST. The panic selling of UST and increase in the supply of LUNA resulted in the crash of both stablecoins.