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The collapse of TerraUSD (UST) and dilution of LUNA

Amid crypto market crash, the LUNA’s massive drop seemed to have caught the attention of most traders.

The first warning signs came when the UST stablecoin slipped from its dollar peg to $0.985 on May 8, before restoring the parity 16 hours later. In response, the Luna Foundation Guard (LFG) — a non-profit overseeing the Terra (LUNA) ecosystem — has voted to lend $1.5 billion worth of crypto to unnamed “professional market makers” to protect its native stablecoin UST.

That didn’t help and within the next few days UST has plummeted below $1 due to a well-funded coordinated attack. According to the official announcement, the Luna Foundation Guard (LFG) depleted its reserves of around $3 billion in crypto trying to defend the UST peg.

UST is an algorithmic stablecoin that is essentially backed by LUNA tokens via the mint-and-burn mechanism, so LUNA price nosedived together with UST.

The total supply of LUNA has been hyperinflated as the protocol tried to restore the UST peg by creating new LUNA tokens in exchange for burning UST. As a result, traders buying LUNA were providing exit liquidity to those trying to get rid of UST.

Since many retail investors didn’t understand that LUNA’s supply has been massively diluted from less than a billion to trillions of tokens, they tried to “buy the dip” hoping that the price will at least partially recover.

In a completely free market such a situation could have led to an interesting scenario in which the amount of capital poured into LUNA by speculators would have been enough to bail out the bad debt accumulated by the Terra ecosystem and to potentially restore the UST peg over time.

However, a few things stopped the system from rebalancing itself.

  • Due to a high risk of a governance attack, the Terra team decided to stop voting power delegation of newly minted tokens, then completely froze the mint-and-burn mechanism, and even temporary stopped the Terra network altogether.

  • Binance pulled out the plug by halting LUNA trading to protect its customers from making poor trades.

Since Binance accounted for the majority of LUNA’s trading volume, the price quickly plummeted and reached an all-time-low of around $0.000001 with just over $6 million market cap on May 13, according to CoinGecko.

Following hours of negotiations, Binance has re-enabled LUNA’s trading, while the Terra blockchain has been restarted without the mint-and-burn feature, which essentially meant that the Terra team decided to give up on UST’s peg.

Due to high buying pressure, on May 14 the price of LUNA skyrocketed to nearly $0.0006 with a market cap over $4 billion — a 60000% increase from its all-time-low a day earlier. In the next few days the market has cooled down and LUNA’s market capitalization has been hovering around $1.5 billion.


Terra vs Terra Classic

Meanwhile, the Terra community has been debating for days over the possible solutions to revive the system and compensate investors, ranging from a hardfork to an airdrop of LFG’s remaining reserves to small UST holders before the attack.

On May 16, Terra founder Do Kwon confirmed his intention to give up on the UST peg and proceed with a fork, naming the old chain as Terra Classic with a native token Luna Classic (LUNC), referring to the Ethereum’s DAO hack, which divided the chain into Ethereum (ETH) and Ethereum Classic (ETC).

The fork proposal, however, received very polarized feedback with many investors being in favor of shrinking LUNA supply without a fork, and many developers — who were promised to receive up to 5% of new LUNA token’s supply — pledging their support for the new chain. At the time of writing, the controversial proposal has received 27.06% of the 50% necessary tokens for passing, with a 84.76% of them signaling its approval.

In other news

  • Portugal’s minister of finance announced that crypto assets will soon be subject to a 28% capital gains tax. Before the announcement the country had a reputation of a crypto tax haven.

  • After disabling UPI payments, Coinbase CEO blamed India’s central bank for “informal pressure” - also known as a “shadow ban” - which goes against the Supreme Court ruling that cryptocurrencies cannot be banned.

  • Germany’s Ministry of Finance announced that investors will receive a capital gains tax exemption after holding crypto assets like Bitcoin (BTC) and Ethereum (ETH) for one year.

  • Representatives of central banks and financial institutions from 44 countries have met in El Salvador to discuss a series of topics including Bitcoin adoption. El Salvador became the world’s first country to recognize Bitcoin as legal tender in 2021.

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