Terra (LUNA), a public blockchain protocol that powers a number of non-collateralized stablecoins, will be long remembered for unleashing the crypto sphere’s first “Lehman” moment as the whale-sized volatility quakes and the corresponding contagion emanating from TerraUSD (UST) losing its $1 peg spread to virtually every corner of the market, hammering Bitcoin and causing Tether to briefly lose its peg.

Before delving into the details of this crisis, let’s go over a quick refresher course. Terra maintained UST’s $1 peg by algorithmically adjusting the supply of UST and LUNA. If the price of UST fell below $1, the supply of UST was burnt by minting $1 worth of LUNA, entailing a swap fee that was paid in LUNA coin. This reduced UST’s supply and allowed the peg to be restored. On the other hand, if the price of UST exceeded $1, LUNA was burnt to mint $1 worth of UST, entailing a swap fee paid in UST, thus increasing the stablecoin’s supply and reducing its price. These swap fees played an important role in funding staking rewards. Moreover, the swap fee tolerance determined the amount of LUNA/UST that could be burnt or minted at a given time. Check out this Twitter thread for more details on this topic:

Crypto’s “Lehman” Moment Eviscerates Terra’s UST, Pummels Bitcoin, and Shakes up Tether

Update on Luna Tokenomics
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How to predict when depeg will end.

Bringing back my “death spiraling Luna” model. Turns out it was accurate. All of those “Didn’t age well” jabs at it Didn’t Age Well.

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— Pedro (@pedroexplore1) May 11, 2022

With this primer out of the way, let’s go over what went wrong. Terra’s algorithmic approach toward stablecoins worked relatively well during periods of low volatility. However, it has utterly…