In four years, Terra rose to the highest tier of cryptocurrency projects, with its underlying blockchain touted as a major competitor to Ethereum’s. The performance of the Terra blockchain and its emerging decentralized finance (DeFi) ecosystem saw its native token, LUNA, gain more than 10,000% in 2021.
Terra’s strong performance continued into 2022, becoming one of the only top projects to record a new all-time high in a year of predominant price decline. However, an unexpected turn of events in May saw Terra’s multi-billion-dollar project fall to nothing in a few days. So, what caused the Terra market crash?
The Terra Ecosystem Crash: What Really Happened?
One of the biggest parts of the Terra project was its algorithmic stablecoin, TerraUSD (UST). However, it turned out to be Achilles heel for the amazing project Terra was building. Unlike conventional stablecoins that derive their value from being fully backed by reserves, the algorithmic UST was linked to Terra’s native token, LUNA.
Instead, the UST derived its value from code, constant market activity, and sheer belief to keep its peg to the dollar. So, what went wrong with TerraUSD? Why did it trigger a market crash?
The Reason Behind the Terra-UST Crash?
The UST was becoming remarkably popular among investors, not for its 1:1 dollar peg, but to profit 20% from buying and lending it to a defi project, Anchor. UST quickly earned the title of the “gold standard for passive income on the blockchain.”
Although it was launched as a means to raise awareness for the algorithmic stablecoin, mega whales quickly jumped into Terra. The total value locked in Anchor quickly hit $17 billion, representing about 70% of all value in the Terra defi ecosystem.
With these wealthy investors short-selling the UST – borrowing huge amounts of Bitcoin to buy UST and claim the profit, Terra was unable to keep up with the payment. This caused UST to de-peg (being valued under $1) from the dollar.
After the first major de-pegging scare on May 8, investors on Anchor scrambled to get their profits out by dumping the stablecoin. The sell-off of the UST caused the stablecoin to lose its peg in subsequent days. Because the UST was linked to LUNA, the altcoin was caught in a death spiral, crashing from $116 in April to $0.000178.
As a result of the crash, over 300,000 Terra investors lost their money, with some running into billions. Although Terra investors felt the immediate impact of the UST de-pegging, the weight of the crash quickly subdued the crypto market.
Ripple Effect of the Terra Crash
The Terra ecosystem crash only exacerbated the decline of cryptocurrencies in 2022. In the span of a week, the global crypto market lost a cumulative $600 billion in capitalization – one of the most painful weeks for cryptocurrency investors ever.
The Global crypto market cap for May.
This happened when the Luna Foundation Guard (LFG) sold more than $3 billion worth of Bitcoin in its reserves to defend the UST peg. Failing to defend the peg, the crash caused huge downward pressure on the market, causing other large investors to sell off their Bitcoin. Other altcoins also joined Bitcoin’s sharp decline – a full-blown market crash.
How Does Terra’s Crash Affect the Crypto Industry?
Although the price drop across the crypto market is immediately the most profound effect of the Terra crash, its effect extends even further.
Terra’s short-term success hasn’t stopped regulators across the globe from calling for a regulatory framework for stablecoins. Commenting on the impact of Terra has had on investors across the globe, crypto analyst Sam Reynolds believes it is;
“likely to lead to a further tightening of rules surrounding crypto firms registered in Singapore for jurisdictional preference yet conducting business primarily abroad.”
The same view is shared by regulators in most countries, with the U.S., U.K. and European Union calling for stablecoin regulation. Some analysts believe a quickfire response from regulators on a panicking market could greatly impact algorithmic stablecoins and the broader crypto market.
Crypto Funding May be Affected
Over the last few years, crypto projects have enjoyed an astonishing amount of funding from venture capitalists. Terra was one of the most beloved projects by venture capitalists.
However, experts predict that crypto investments could begin to slow, with venture capital investors like Andreessen Horowitz, Pantera Capital, Three Arrows Capital, Republic Capital, GSR Ventures Tribe Capital, and Delphi Digital losing over $1 billion.
Uncertainty in the Stablecoin Sector
Stablecoins, in general, have faced the most pressure since the UST lost its peg. Just days after the UST incident, Tether (USDT), the world’s biggest stablecoin, briefly lost its peg before quickly regaining it.
To ease investors’ concern, Tether announced that the project is 100% backed, stating that the stablecoin is also partially backed by non-U.S. government bonds. In addition, ambitious blockchain developers may reduce their experimentation with stablecoins.
A Major Hit on Decentralized Finance (DeFi)
Between January 2021 and May 2022, Terra’s defi ecosystem grew from $53 million to as high as $32 billion. However, within days, the value locked in Terra has plunged to $130 million. Not only has one of the biggest defi ecosystems failed, but most interoperable defi protocols of other chains where Terra (LUNA) and UST are used also took a hit.
Terra’s crash also revealed many centralized pressure points in the decentralized ecosystem, which has been significantly bent by the crash. With a recovery plan already in motion for Terra, it remains to be seen how much more resilience is left in the project.
In a Nutshell
The effect of the Terra (LUNA) and TerraUSD (UST) crash clearly spreads beyond the Terra ecosystem, indirectly touching every crypto project. The impact of the crash on the entire cryptocurrency industry can either be quelled or exacerbated, depending on the outcome of the Terra recovery plan and the next actions taken by regulators from all over the world.