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The bitcoin market isn’t looking good. Bitcoin and ether are at their lowest levels since 2020, and altcoins such as dogecoin and cardano are performing even worse. While the drop is distressing for crypto investors, it is not unprecedented. Cryptocurrencies are notorious for their volatility, and turbulent economic conditions are bringing not only crypto, but also the stock market down.

The collapse of the luna cryptocurrency and its accompanying terra USD stablecoin, dubbed UST, is unprecedented. You may not be familiar with UST or what a stablecoin is, but it’s a significant deal. Hundreds of millions of dollars in cryptocurrency riches have vanished, sending shockwaves through the market.

The UST stablecoin and luna, both of which are part of the terra blockchain, have two connected stories. The UST coin is supposed to have a constant value of $1, but it was depegged last Monday, May 9, and is now only worth 17 cents. Then there’s luna, the ecosystem’s beating heart. Its value has plummeted in one of the most spectacular cryptocurrency crashes ever seen.

The price of the coin has dropped from $116 in April to less than a penny on Thursday. It’s dropped much more, trading for a fraction of a cent over the weekend. Luna has dropped to an eighth of a penny at the time of writing. Small-cap memecoins have witnessed similar collapses before, but never for a coin the scale of moon, which had a market cap of nearly $40 billion just last month.

Mike Boroughs, co-founder of crypto investing firm Fortis Digital, stated, “This is momentous for the crypto markets.” “Because of its size and significance in terms of the number of people who lost significant value, this is a defining event for the space.”

Here’s everything you need to know about it.

What exactly is a stablecoin?

To comprehend the crypto-crisis, you must first comprehend what a stablecoin is. It’s essentially a cryptocurrency tied to a more stable currency. Tether and USDC, the two most popular stablecoins, are both connected to the US dollar, as are other stablecoins. So, if you have 1,000 USDC tokens, you can trade them for $1,000 at any moment.

Stablecoins are a key component of “DeFi,” or decentralised finance, and were created to help investors protect themselves from the volatility of the bitcoin market. If ether costs $2,000, a trader might get 2,000 USDC coins for one ether. If ether decreases 50% to $1,000 tomorrow, the 2,000 USDC tokens are still worth $2,000 and may be exchanged for two ether tokens. When investors anticipate a downturn, they buy in stablecoins like as tether, USDC, and, until this week, UST.

Stablecoins also allow for bitcoin lending and borrowing, making them an important DeFi technology.

The terra/UST coin differs from tether and USDC in one important way: it is an algorithmic or decentralised stablecoin, rather than being backed by actual US dollars. The notion is that the UST’s dollar peg can be maintained without relying on the currency thanks to a few smart processes and billions in bitcoin reserves.

“The Holy Grail of DeFi is a decentralised stablecoin,” said Cyrus Younessi, former head of risk management at MakerDAO, the firm behind DAI stablecoin. The difficulty for bureaucrats, politicians, and central bankers to control bitcoin and ether is a selling feature, but the negative is price volatility. “It would be amazing if you could take those assets, extract stability from them, and productize it,” Younessi added. “However, it isn’t particularly viable.”

What are Terra, Luna, and UST?

Terra, like ethereum and bitcoin, is a blockchain. While Ethereum’s blockchain generates ether tokens, Terra’s blockchain generates luna tokens. Luna was trading for $85. before the depeg.

To make UST, you must first burn luna. Last week, for example, you could sell one luna token for 85 UST (since luna was valued $85), but the luna would be destroyed (“burned”) in the process. The purpose of this deflationary strategy was to assure Luna’s long-term growth. As more individuals invest in UST, more luna will be burned, increasing the value of the remaining luna supply.

To attract traders to burn luna to create UST, the Anchor Protocol provided a mind-boggling 19.5 percent yield on staking — which is effectively crypto slang for earning 19.5 percent interest on a loan. Instead of putting your money in a bank where it will earn 0.06 percent interest, the pitch is to put it in a UST where it will earn over 20% interest. Prior to the depegging, this scheme held approximately 70% of UST’s circulating supply, or around $14 billion.

The following is the key to UST maintaining its peg: A single UST can always be traded for one luna. So, if UST drops to 99 cents, traders might profit by buying a large quantity of UST and exchanging it for luna, making a 1 cent profit per token. The effect works in two ways: people buying UST drives up the price, and UST being burned during its conversion to luna drives down supply.

Two weeks ago, $LUNA was $82.

Current Price: $0.00018

— Watcher.Guru (@WatcherGuru) May 17, 2022

Finally, there are the reserves. Do Kwon, the founder of Terra, established the Luna Foundation Guard, a group tasked with safeguarding the peg. The LFG now has $2.3 billion in bitcoin reserves, with aspirations to increase this to $10 billion in bitcoin and other digital assets. If UST fell below $1, bitcoin reserves would be liquidated and the money used to purchase UST. If UST rises above $1, its founders will sell it until it falls below $1, then use the profit to buy more bitcoin to replenish the reserves.

Everything makes sense. However, UST is currently worth 17 cents at the time of writing.

What went wrong, exactly?

On Saturday, May 7, it all began. UST worth over $2 billion was unstaked (taken out of the Anchor Protocol), with hundreds of millions of dollars traded instantly. It’s unclear if this was a reaction to a particularly tumultuous moment — rising interest rates have had a significant impact on cryptocurrency pricing — or a more deliberate attack on Terra’s system.

The price dropped to 91 cents as a result of such large sells. Traders tried to take advantage of arbitrage, exchanging 90 cents worth of UST for $1 worth of luna, but then a speed bump appeared. Only $100 million of UST can be burned every day for luna.

Investors, already flighty in the current gloomy market, flocked to sell their UST once the stablecoin couldn’t retain its peg. It bounced between 30 cents and 50 cents in the week following the initial depeg, but has now fallen to a steady low of under 20 cents. Its market cap, which was around $18 billion in early May, now stands at $2 billion.

It’s worse for luna holders. The value of luna tokens has almost completely disappeared: After reaching a high of just under $120 in April, luna’s current price is a fraction of a penny.

On the possibility of this being a malicious attack. Some have speculated that an attacker attempted to break UST in order to profit from shorting bitcoin — that is, betting on its price going down. If would-be attackers created a large position in UST and then unstaked $2 billion at once, it could depeg UST, which would mean terra’s team would have to sell portions of its bitcoin reserve to repeg the stablecoin. Once investors saw that UST lost its peg, they would then rush to unstake and sell their UST, which would require more bitcoin reserves to be sold, adding further sell pressure.

Again, this is still speculation. Younessi is unsure whether the depeg was caused by a coordinated attack or not, but said that the responsibility is on crypto developers to create more secure systems.

“Our job as DeFi builders is to build systems that are resistant [to exploits],” he said. “That’s literally in the original threat model that anyone in crypto builds: How would this hold up if a guy with $100 billion came in and tried to take this down?”

Four years ago, while working as a DeFi analyst at Scalar Capital, Younessi called Terra’s model “broken”.

“Terra could have grown to be 10 times as large” before such a crash, he said to CNET. “Better that we prick that bubble of unsustainable protocols sooner than later.”

Why does it matter?

This matters for three reasons.

First, over $15 billion in crypto value has been wiped out through luna and UST alone. There have been anecdotal reports of self-harm by those who had most of their savings staked in UST — though these can’t be confirmed, it’s clear that a lot of people lost a lot of money in the collapse. The damage isn’t contained to terra’s ecosystem though, as Fortis Digital’s Boroughs notes. Many who were exposed to luna and UST would have sold off big parts of their crypto portfolio to recoup some of the damage, pulling the entire market down.

Second, it raises questions about other stablecoins. Again, UST was unusual in that it was an algorithmic stablecoin, unlike tether and USDC. But the stability of those coins has always been somewhat in doubt: For instance New York’s attorney general last year accused tether of lying about how much it actually held in dollar reserves.

Boroughs worries that, if UST was attacked, similar plays could be made against the others.

“The question in our minds becomes, does what happened to UST spread to other stablecoins?” he said. “If big whales found a playbook here that works to attack UST, we worry they may reuse that playbook in other areas of the market.”

Last, and possibly most significantly, the collapse of UST has caught the attention of powerful politicians and regulators. Secretary of the Treasury Janet Yellen said on Tuesday that UST’s depegging “simply illustrates that this [stablecoins] is a rapidly growing product and there are rapidly growing risks.”

“One place we might see some [regulatory] movement is around stablecoins,” Securities and Exchange Commission member Hester Pierce said Thursday

What’s next for luna and UST?

It’s been a rough week for terra developers since UST depegged on May 10. Prominent figures have asked pertinent questions about Terra’s bitcoin reserves, and the terra blockchain has stopped operating on two occasions. Meanwhile, Do Kwon, CEO of Terra Labs, says he has a plan to restore Luna’s value and repeg UST.

As noted above, the Luna Foundation Guard had around $2.3 billion worth of bitcoin. In the event of a depegging, those reserves were to be sold, with the resulting liquidity used to buy UST back up to $1. So why didn’t it work?

Some have questioned how the LFG actually used the money. Over the course of a day, on May 9, around $1.6 billion worth of bitcoin was sent from LFG’s wallet to Gemini, a crypto exchange. Another $875 million was sent to a wallet on Binance, the world’s biggest crypto exchange. What happened from there can’t be traced on either Gemini or Binance.

That lack of transparency has many confused — including Changpeng Zhao, the founder and CEO of Binance. “Where is all the BTC that was supposed to be used as reserves?” he tweeted Saturday. “Shouldn’t those BTC be ALL used to buy back UST first?”