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Terra collapses: LUNA crashes – UST loses price maintenance

 


TerraUSD is suffering the very fate that many skeptics warned about from the start. The stablecoin does not experience its price peg to the dollar through currencies deposited with the bank or through assets denominated in US dollars.


Instead, TerraUSD guarantees its price maintenance by burning LUNA when UST is issued and vice versa. So you take one asset off the market to support the price of the other. This creates arbitrage opportunities because the demand for the stablecoin can fluctuate, which usually only results in minimal deviations from the price fixing.


To further secure TerraUSD, the Luna Foundation Guard bought up billions of dollars worth of bitcoin and announced a reserve of up to $10 billion in bitcoin. This reserve was used by lending bitcoin, but this proved ineffective. As a result, LUNA is now at just $2.51 and UST has moved far away from price maintenance and is trading at $0.50. UST temporarily fell as low as $0.20 before recovering slightly.


How could that happen?

The mechanism described above ensures that UST is always around USD 1 despite fluctuating demand. But if the stablecoin is well below $1 for an extended period, then market participants have an incentive to buy UST and burn it for LUNA. By selling LUNA, which they have won in this way, they then make a profit again.


But this creates a spiral. Because the price pressure on LUNA will only increase if the stablecoin does not return to its approximate value of $1. Adding to the pressure on LUNA price from arbitrage trading is declining confidence in TerraUSD and LUNA. Because investors who hold UST then also want to jump off and either exchange UST for other stablecoins or burn them in exchange for LUNA.


In the end, the amount of LUNA in circulation keeps increasing, while at the same time the price and thus the confidence in the coverage of UST keeps falling. Exactly for this reason, a BTC reserve was obtained, which turned out to be useless.


Did Terra fail?

The Terra blockchain has arguably found its greatest use case in TerraUSD. However, with the collapse of LUNA and UST, the project has been sidelined. After such a total loss, why should you ever trust UST and LUNA again?



The basic prerequisite for this would be at least a full recovery from UST, which is currently being planned and, according to Do Kwon, will be a long time coming. The aim will be to better compensate for the resulting surplus by adjusting the mint burn parameters.


It remains to be seen whether this can succeed. In any case, the “death spiral” continued to turn happily up to the editorial deadline.

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