Why Terra (LUNA) Is Down Over 50% Today

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Terra (LUNA)'s price has plummeted after the network's TerraUSD (UST) stablecoin lost its peg. After posting significant gains earlier this year, LUNA has fallen by over 50% in the past 24 hours.

The attraction of stablecoins is that -- in theory -- they aren't affected by the price volatility that impacts other cryptocurrencies. However, in yesterday's crypto crash, the value of 1 UST sunk as low as $0.66, according to CoinGecko, eroding confidence in the entire Terra network. At time of writing, UST is trading at $0.92.

How UST lost its peg

There are different types of stablecoins, each of which carries its own risks. For example, Tether (USDT) and USD Coin (USDC) are both fiat-backed stablecoins, which means they should have $1 in reserve to support each token they issue. But there's not always a lot of transparency surrounding those reserves.

UST is an algorithmic stablecoin, which means computer codes work in the background to maintain its price. Essentially, smart contracts burn or mint UST or LUNA, Terra's native token, to increase or decrease the value of UST. As we wrote a few weeks ago, the risk is this system may not hold up against extreme price volatility, causing Terra's stablecoins to de-peg.

LUNA soared earlier this year, in part because of the high demand for UST on its Anchor Protocol. Anchor promised APYs of almost 20% on UST deposits, which is all very well when times are good. Unfortunately, as we saw this weekend, the system may not be sustainable during times of extreme turbulence and panic.

The Luna Foundation Guard, a nonprofit dedicated to supporting the Terra ecosystem, has been buying Bitcoin (BTC) in recent months as part of a fund that's designed to prop up Terra's stablecoins. It's working toward a reserve fund of $10 billion, intending to prevent any de-pegging incidents. This is good in theory, but in practice it did not work.

When UST first lost its peg over the weekend, the Luna Foundation tweeted that it would make two $750 million loans, one to accumulate BTC and the other to protect the UST peg. The price of UST continued to drop. As jitters over UST spread, more investors tried to sell, causing what's best described as a run on UST.

The founder of Terraform Labs, Do Kwon, blamed deliberate market manipulation. But neither his words nor the efforts of the Luna Foundation could stem the flow. Other top cryptos are starting to stabilize after heavy losses in recent days. However, LUNA's price continues to fall and 1 UST is still not worth $1.

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What it means for investors

Decentralized finance (DeFi) promises to take the middleman out of traditional financial services, offering high rates of return on deposits, reducing fees, and making banking services more accessible. However, as recent events demonstrate, it is a work in progress.

Some aspects of DeFi overturn banking models that have taken decades to develop, including the consumer protections that many Americans take for granted. Those with UST on Anchor's platform may be able to earn high rates of interest for a short time, but there's a risk. If UST collapses, as other algorithmic stablecoins have, those investors would lose it all.

Not only did Terra's reserve fund fail to hold up the value of its stablecoin, some say Luna Foundation's rush to sell Bitcoin flooded a falling market with even more BTC and could have caused prices to drop even further. Both LUNA and UST are in the top 20 cryptos by market cap and if they fail, it will add additional pressure to the wider crypto market at what is already a worrying time.

Bottom line

Stablecoins are an increasingly important part of the cryptocurrency industry. The trouble is that if any of these large stablecoins fail -- whether it's USDT or UST -- it could damage the entire crypto ecosystem. As a result, LUNA's 50% price drop is cause for concern for all crypto investors, not just those who hold UST or LUNA.

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Emma Newbery owns Bitcoin, Terra, and USDC. The Motley Fool owns shares of and recommends Bitcoin.

We're firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.Emma Newbery has positions in Bitcoin and Terra. The Motley Fool has positions in and recommends Bitcoin and Terra. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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