The LUNA and UST crash explained in 5 charts

The LUNA and UST crash explained in 5 charts

One of the first signs that things were going wrong for Terra was when UST deposits at Anchor began to drop on Saturday.

The Terra money machine has all but collapsed today. UST stablecoin remains low in the sub-dollar range for the third day in a row, and LUNA, its sister token, is down nearly 97% from its 2022 peak. The near-total failure of one of the darlings of the decentralized finance world (DeFi) is an important lesson in the systemic risks of algorithmic stablecoins - the elusive holy grail of cryptocurrency.

To understand why Terra collapsed last week, one must understand its Achilles heel - the anchor lending protocol.

One of the first signs that things were going wrong for Terra came when UST deposits on Anchor began to fall on Saturday.

Anchor offers market-leading returns of up to 20% a year to users who deposit their UST on the platform. Before the UST decline began late Saturday, 75% of LUNA's total circulating supply was on Anchor. That's 14 billion UST out of a total circulating supply of $18 billion.

With so many UST tied up in Anchor, it became clear that most investors were buying the stablecoin with the sole intention of reaping the sweet, sweet Anchor returns. Depending on whom you ask, the relationship between Anchor and UST was either an ingenious mechanism to provide value to the fledgling stablecoin or a wasteful marketing effort that attracted stingy mercenary capital.

Critics said Anchor's high returns were unsustainable and artificially inflated by Terraform Labs (TFL) and its backers. A drop in returns would have caused UST depositors to flee Anchor (and UST) in search of higher returns, the critics said.

The system was similar to that of fledgling Uber, where VCs subsidized ride costs to achieve long-term market dominance. Instead of cheaper cab rides, inflated anchor rents were used to draw people into the Terra ecosystem - hopefully permanently. The problem, critics said, was that TFL and its partners couldn't afford to subsidize investors for so long. Eventually, the money would dry up, and so would Anchor's customers (and UST's willing owners).

Although Anchor was never forced to cut its yields too much, UST deposits fell sharply by earlier this week, from $14 billion to just $3 billion. The outflow of so much money from the main UST hub signaled a massive loss of confidence in the entire UST protocol. Since there are few uses for UST other than Anchor, most withdrawals from the platform likely ended up on the open market.

As might be expected, the massive outflow from Anchor to the open market resulted in significant selling pressure on the Terra ecosystem.

UST, a so-called algorithmic stablecoin, works with its sister token, LUNA, to keep the price at $1 by employing a series of on-chain mint-and-burn mechanisms. In theory, these mechanisms are designed to ensure that $1 worth of UST can be used to mint $1 worth of LUNA - serving as a sort of floating price shock absorber for UST volatility.

The massive selling pressure led to a sharp drop in the price of both LUNA and UST. Eventually, LUNA's market capitalization exceeded UST's for the first time. When there was no longer $1 of LUNA for $1 of UST, some alert traders feared that the entire system might become insolvent (since UST holders would have no clear way to "cash out" in LUNA in the event of a full-scale bank run). Whether or not this fear was justified (we'll talk about LUNA's bitcoin backstop in the next section), it's hard to imagine that the psychological impact of UST and LUNA's price plunge and market cap "flip" didn't trigger even more selling.

To prop up the UST price, the Luna Foundation Guard (LFG), Terra's official peg defender, put over $2 billion into its newly formed bitcoin reserves.

Do Kwon has begun sweeping BTC off the market in recent months to shore up Terra if the exchange rate ever needs defending.

In its first (and perhaps last) test of this mechanism, LFG has "loaned" billions of dollars worth of reserves to professional market makers, almost completely emptying LFG's blockchain wallets in the process.

While LFG now struggles to replenish its empty reserves with new investors, market makers are scrambling to actively defend Terra's peg by providing rescue capital to exchanges and liquidity pools.

While rescue capital from Terra's reserves was moderately successful in driving up UST and Luna prices on Tuesday, the prices of both tokens were extremely volatile until the early hours of Wednesday morning.

At that point, all bets seemed lost for a smooth UST recovery. Even as Do Kwon announced on Twitter that a rescue plan for Terra was in the works, the market's confidence in the project seemed to drop to an all-time low. At one point, LUNA, which was priced above $120 at the beginning of the year, fell below a dollar. UST dropped below 30 cents for a brief moment, leading to questions about whether the "stable" coin can ever regain its stability.

Much of the hundreds of millions of dollars in Bitcoin used to bail out UST was likely sold directly to the market earlier this week. Payouts in non-BTC currencies would have been necessary for traders hoping to defend Terra's bond.

The charts of net BTC transfer volumes illustrate this, showing massive spikes in volume on May 9 and 10, when Terra's reserves were first deployed. While Terra is not responsible for the entirety of these spikes, billions of dollars in released Terra reserves would certainly have had an impact.

Terra's BTC reserves likely increased selling pressure in an already turbulent market.

UST's impact on the broader market is an important footnote amid this week's chaos. It's a reminder of why stablecoins - which are the foundation of decentralized finance - pose not only a risk to individual traders, but also a systemic risk to the entire crypto ecosystem if not managed responsibly.

Don't be surprised if regulators come knocking.