Ringle is not a financial advisor and the below article does not constitute financial advice.
A 50 trillion won crypto collapse has catapulted [1] terra and luna into the limelight. Invented by South Korean engineer Do-Hyung Kwon, terraUSD stablecoin (also called UST) and luna cryptocurrency were once heralded as a hit—before crashing and being criticized as newfangled nonsense. In December 2021, terra's market capitalization was stated to be 23 trillion won, while luna's reached 39 trillion won.
However, a downward pressure on these coins caused an extreme sell-off, resulting in their market prices plummeting; in May 2022, terra plunged 57%, and luna plunged 99% from their highest points, respectively, wiping out a total value of 50 trillion won, which amounts to the market capitalization of Naver, a South Korean IT behemoth.
Terra is a “stablecoin,” advertised to have limited volatility. Stablecoins are cryptocurrencies pegged to traditional fiat currency [2], and in this case, terra is pegged to USD; this is where luna comes in. Terra’s value is pegged to USD by way of luna, a sort of sister token, creating an intricate see-saw mechanism.
*Peg means to drive a stake into the ground and to fix it firmly. In crypto, it means to fix (stabilize) the volatility of a cryptocurrency, in this case, by guaranteeing its exchange ratio against the (US) dollar.
Much hype was formed around terra as it was advertised that investors could secure up to 20 percent of its invested amount as interest. According to the scheme, the interest would be paid in luna, not in dollars. With this algorithm promising a stable price and a hefty return, terra once ranked as one of the world’s top 3 stablecoins.
Algorithmic collapse
Despite the claim that the coin will be pegged to the US dollar through a see-saw algorithm, the value of terra has ended up trending to less than a dollar. Because the stablecoin failed to live up to the name, people’s confidence on terra and luna gradually started to wane.
Terra bank run
The concept of a bank run is key to understanding terra’s collapse. When a large number of people lose confidence in a bank, believing that it may cease to function due to extreme political or economic instability, they rush to withdraw their deposits. This is what is called a bank run. If the total amount of cash that people want to withdraw exceeds the bank’s reserve fund for deposit, the bank becomes insolvent [3] and goes bankrupt.
As luna and terra began to plummet in value, anxiety spread quickly among investors. They were afraid that they could no longer get the promised interest or exchange their coins for dollars. This led to the crypto equivalent of the bank run, and the value of a luna coin plummeted to around $0.00002 within a few days. Bloomberg reported this dramatic crash saying that the coin was: “heading towards a death spiral."
What will happen to terra and luna?
The terra luna incident shocked the market; several coin exchanges around the world are in the process of unlisting both terra and luna coins. The entire cryptocurrency market contracted significantly, with Bitcoin prices plunging and new investment inflow drying out. Some media likened the incident to the Lehman Brothers crisis in 2008, predicting that the virtual currency bubble might burst in the wake of this crash. The incident also triggered financial supervisory institutions to use their magnifying glasses on other cryptocurrencies with equally high promised interest rates.
In a traditional bank with fiat currency, deposits are secured by the government and the central bank. In an American bank account, money is secured by the Federal Deposit Insurance Corporation or FDIC, which guarantees funding should a bank be unable to properly pay its customers. A major challenge for crypto and in particular stablecoins moving forward will be ensuring that deposits on volatile exchange markets can be truly backed by important assets similarly to other currencies.
Conventional wisdom says to buy low and sell high—and as long as the market exists, investors will act on this mantra. However, seeing another terra luna crash is not out of the realm of possibility, and the age-old wisdom might be perpetuating [4] the cycle of bubbles and crashes. That said, how the terra and luna crash will shape the future coin market still remains to be seen.