The last few days have been hard for crypto investors. The nosedive journey of the LUNA coin has intensely shaken the whole crypto market. This LUNA crash has turned the worst nightmares of many LUNA investors come true. Not just LUNA and its sister coin TerraUSD, but Bitcoin and other altcoins also struggled amid the steep crash of LUNA.
But what exactly happened? Why did LUNA and TerraUSD crash? How is it affecting other cryptocurrencies? Will the market recover?
If these questions are shooting up in your crypto-curious minds, you have come to the right place.
To prevent you from being overloaded with tons of technical information, we will take it slow by first understanding what LUNA is and how it works.
What is LUNA?
LUNA is the native token of the Terra network. It is a cryptocurrency whose value connects to TerraUSD, which is another native token of Terra. Being an algorithmic stable coin, TerraUSD maintains its peg value with the US dollar through an algorithm.
In this algorithm, LUNA works as collateral for the TerraUSD (UST). You can always exchange 1 TerraUSD for $1 worth of Luna. A user must burn LUNA equal to the number of TerraUSD he wants to mint. This way, both TerraUSD and LUNA maintain their stability by following a 1:1 mint and burn ratio.
Has this confused you? Let’s understand it more simply.
1 TerraUSD should be ideally worth $1, and it uses LUNA coins as a counterweight to maintain this value.
Consider the below situations for a better understanding.
* Suppose 1 TerraUSD (UST) = $0.98. Now since investors can exchange 1 TerraUSD for $1 worth of Luna, they will buy $1 worth of LUNA at $0.98 by burning their TerraUSD and make an instant profit of $0.2 per LUNA.
If more investors start burning TerraUSD to make this $0.2 profit, the supply of TerraUSD will become short, and its price will hike. Let’s imagine if its price hikes to $1.02. Then,
* 1 TerraUSD (UST)= $1.02. Now investors will burn their LUNA coin worth $1 to get TerraUSD coin worth $1.02 to make a profit of $0.02 per LUNA coin.
This is how TerraUSD and LUNA used to work generally.
What caused the Luna crash?
In short, the balance mechanism between LUNA and Terra broke because investors started burning their TerraUSD in bulk to convert it to LUNA.
But what broke this balance? Read on to find out.
An anchor protocol exists on the Terra network that allows users to earn interest on their TerraUSD. This protocol pays 20% interest to investors on their TerraUSD holdings. Everything was going well till investors were satisfied with this interest rate. But in March, Anchor planned to introduce variable interest rates for TerraUSD.
Think about what you will do if it happens with your bank saving accounts or fixed deposits. If your bank charges variable interest rates on your deposits, what would be your reaction as a smart individual? You will divert your savings to another bank where you can get higher interest.
The same thing happened with TerraUSD. Thousands of investors started withdrawing their TerraUSD from Anchor and converting them to LUNA coins. At the same time, the TerraUSD price falling below $1 acted as a catalyst in bringing the tsunami of a massive TerraUSD conversion to LUNA. As a result, the supply of LUNA coins flooded the crypto market. It caused the failure of the balancing mechanism between LUNA and TerraUSD. Hence, both these currencies crashed.
This incident was a reality check for all algorithmic stable coins available for trading in the crypto market. Because coins that claim to be stable can go unstable soon if not managed rightly.
Why did the LUNA crash affect the other cryptocurrencies?
All the cryptocurrencies in the crypto market are interconnected. The sudden crash of LUNA created a fear in the crypto investors that led to aggressively bullish sentiments. According to the latest news, the LUNA foundation guard sold Bitcoin worth $3 billion and other tokens like BNB, Tether, USDC, and Avalanche from its reserve to peg the TerraUSD again. This act altered the demand-supply ratio of many cryptocurrencies and made their prices fall in the past few days. Other reasons like geopolitical tensions and increasing inflation have also encouraged this fall.
What is the recovery plan for LUNA?
Undoubtedly, the biggest question of every LUNA investor is if LUNA can recover from such a drastic loss.
Since the whole free-fall journey of the LUNA coin was an eye-opener for the Terra network, it is planning to make a strong comeback. The good news is that the work of damage repair has already begun.
The founder of Terra Labs, Mr. Do Kwon, suggested a rescue plan for LUNA. He showed optimism and a sense of responsibility by stating that the Terra USD failure is a new chance to rise. He has suggested a forking of the Terra chain that will not contain any algorithmic stable coin. After this fork, the old chain will be called Terra Classic ( LUNC), and the new chain will be called Terra (LUNA). Kwon further proposed that the new network will send LUNA coins to the wallet address of Luna Classic staking individuals, Luna Classic holders, residual TerraUSD holders, and Terra Classic core application developers.
Do Kwon plans to make Terra 2.0 a fully community-owned network this time. He suggests allocating a large portion of the token distribution to two parts. The first one is to provide an emergency runway building fund for existing developers of Terra Dapps. The second part is to align the interest of developers in the long-term success of the ecosystem. Kwon also cleared that Terraform Labs and the creators of Terra – will not receive funds in the initial token disbursement. Only 1,000,000,000 LUNA will be available in Terra 2.0.
As per Kwon, the voting on this plan was to begin on May 18, 2022. If this set of proposals gets the consent of the Terra community, the new network launch can come on May 27, 2022.
Will Luna recover?
Though the recovery plan for LUNA is in progress, it is unlikely to recover soon. Even if LUNA comes up with a better configuration and programming, it will take time to regain the trust of crypto investors and the Terra community. Moreover, the forking proposed by Terra is receiving mixed responses from the investors. Many crypto influential personalities are opposing this idea with an argument that forking does not give the new fork any value. Hence, the recovery of LUNA is very uncertain as of now.
