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Why did TerraUSD and Luna cryptocurrencies crash?  Stablecoin Price Crash Explained


A breed of cryptocurrencies touted for their supposed stability have come under intense scrutiny as regulators, individual investors and veteran digital asset traders watch a spiral from its $1 peg to pennies.

The recent fall of TerraUSD and its sister stablecoin Luna has burdened investors with billions of dollars in losses and spilled over to other cryptocurrencies. Their plunge has raised pressing questions about the regulation of digital assets and undermined claims by crypto developers that they could create a new form of financing untainted by the destabilizing bank runs that sometimes occur in traditional finance.

Here’s what you need to know about stablecoins and what happened:

What is a stablecoin?

Cryptocurrencies such as bitcoin are volatile digital assets that are subject to large fluctuations that sometimes occur within seconds. A simple tweet or comment from Tesla CEO Elon Musk can make them move sharply.

Stablecoins are supposed to eliminate this volatility. Through different designs, their value is pegged to that of government-issued currencies like the US dollar. In theory, one stablecoin is equal to one dollar, regardless of the direction in which other cryptocurrencies move.

These coins have become a bigger part of the crypto ecosystem over the past two years, with professional traders and individual investors stashing around $180 billion in them as of mid-May.

Why are they becoming popular?

Traders prefer to buy coins such as bitcoin, ether, and dogecoin using dollar-pegged digital assets because when they buy or sell, only the price of the crypto asset changes.

Stablecoins also enable fast trading without the settlement times associated with government-issued currencies, which can take days. If someone wanted to sell bitcoin and quickly lock in their dollar profits, they could buy a stablecoin immediately on major cryptocurrency exchanges.

How does a stablecoin work?

There are two broad categories of stablecoins: those that are asset-backed and those that are algorithm-backed.

The most popular stablecoins, like tether and USD Coin, maintain their levels with assets. The assets that underpin USD Coin consist solely of cash and short-term US government securities, according to its issuer.

Tether Holdings Ltd. – the issuer of the largest stablecoin by market value, tether – says its value is backed by both safe investments, such as cash and short-term US government securities, and riskier investments, including including short-term IOUs called paper trades, secured business loans, and other cryptocurrencies.

So-called algorithmic stablecoins are not backed by assets, but rather use financial engineering to maintain their links to the dollar.

In the past, the algorithmic stablecoin TerraUSD maintained its $1 price by relying on traders to perform an arbitrage function between the values ​​of Terra and Luna. When Terra fell below the peg, traders would “burn” the stablecoin – removing it from circulation – by exchanging TerraUSD for $1 worth of new units of Luna. This action reduced the supply of TerraUSD and increased its price.

Conversely, when the value of TerraUSD exceeded $1, traders could burn Luna and create new TerraUSD, thereby increasing the supply of stablecoins and bringing its price back towards $1.

Do Kwon, a South Korean developer, created TerraUSD. The coin launched in 2020 and before its collapse had grown to a size of over $18 billion.

Markets have looked increasingly fragile lately: stocks, bonds, and crypto have all fallen as investors struggle to navigate the big swings rocking financial markets around the world. The WSJ’s Caitlin McCabe examines some of the causes of the recent market frenzy. Photo: Spencer Platt/Getty Images

What pushed TerraUSD out of its peg?

Traders said the catalyst for the decline – which began the weekend of May 7-8 and snowballed the following Monday, May 9 – was a series of large withdrawals from Anchor Protocol, a kind of bank crypto created by the developers of Mr. Kwon’s company. , Terraform Laboratories.

These platforms are used by digital currency investors to earn interest on their coins by lending them.

By early May, investors had deposited over $14 billion worth of TerraUSD into Anchor, according to the platform’s website. Most of the stablecoin supply was parked on the Anchor platform. Large trades during this May weekend knocked TerraUSD off its $1 value. The instability prompted more investors to withdraw their TerraUSD from Anchor and sell the coin.

This, in turn, led to more investors withdrawing from Anchor, creating a cascading effect of more withdrawals and more sales. TerraUSD deposits at Anchor fell to around $1.6 billion on May 13, according to the Anchor website.

What does this mean for other cryptocurrencies?

A reserve fund of about $3 billion in bitcoin and other cryptocurrency resources, held by the Luna Foundation Guard, a nonprofit co-founded by Mr. Kwon, had been largely depleted as part of a emergency effort to keep TerraUSD pegged in mid-May, according to the fund’s data dashboard. The fund’s sale of large amounts of bitcoin contributed to a sharp drop in bitcoin’s price earlier this week, analysts and traders said.

As TerraUSD and Luna began to fall the week of the selloff, bitcoin also fell, dropping below $26,000 on Thursday, May 12.

What happens next?

Mr Kwon tried to rally his supporters after the two coins were sold. The blockchain underlying TerraUSD and Luna has been shut down twice as its network validators seek to stabilize digital assets.

But TerraUSD and Luna have fallen sharply from their prior values. Many traders sold, expecting that assets could not return to their original levels. And even cryptocurrency enthusiasts say it shook their faith.

What are regulators doing?

The episode also refocused the attention of policymakers on the lack of regulation regarding stablecoins and the broader cryptocurrency market. As TerraUSD decoupled from its peg on May 10, Treasury Secretary Janet Yellen renewed her calls for Congress to pass legislation to govern stablecoins.

At the same hearing, Pennsylvania Sen. Pat Toomey, the top Republican on the Banking Committee, expressed interest in moving quickly on related legislation.

Securities and Exchange Commission Chairman Gary Gensler has spoken in the past about the potential risks that stablecoins pose to investor protection, illicit activity, and financial stability. Mr. Gensler declined to comment on the recent turmoil in the crypto markets.

Paul Kiernan contributed to this article.

Write to Caitlin Ostroff at caitlin.ostroff@wsj.com

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