Why Did Cryptocurrencies TerraUSD and Luna Unravel? Stablecoin Price Crash Explained

Here’s what you need to know about stablecoins and what happened:

What is a stablecoin?

Cryptocurrencies such as bitcoin are volatile digital assets that are prone to big swings that sometimes happen in seconds. A mere tweet or comment from Tesla CEO

Elon Musk

can send them moving sharply.   

Stablecoins are supposed to do away with that volatility. Through different designs, their value is pegged to that of government-issued currencies like the U.S. dollar. In theory, one stablecoin equals one dollar, no matter which way other cryptocurrencies are moving.

These coins have become a larger part of the crypto ecosystem over the last two years, with professional traders and individual investors alike having stashed around $180 billion in them as of mid May.

Why are they becoming popular? 

Traders prefer to buy coins such as bitcoin, ether and dogecoin using digital assets that are pegged to the dollar because when they buy or sell, only the price of the crypto asset varies. 

Stablecoins also allow for fast trading without the settlement times associated with government-issued currencies, which can take days. If someone wanted to sell bitcoin and quickly lock in their dollar profits, they could buy a stablecoin immediately on major cryptocurrency exchanges. 

How does a stablecoin work? 

There are two main categories of stablecoins: those that are backed by assets and those that are backed by algorithms. 

The most popular stablecoins, like tether and USD Coin, maintain their levels with assets. The assets backing USD Coin consist only of cash and short-term U.S. government securities, according to its issuer.

Tether Holdings Ltd.—the issuer of the largest stablecoin by market value, tether—says its value is backed by both safe investments, such as cash and short-term U.S. government securities, and riskier ones, including short-term IOUs known as commercial paper, secured loans to companies and other cryptocurrencies.

So-called algorithmic stablecoins aren’t backed by assets, instead using financial engineering to maintain their links to the dollar. 

In the past, the algorithmic stablecoin TerraUSD maintained its $1 price by relying on traders to take on an arbitrage function between the values of Terra and Luna. When Terra fell below the peg, traders would “burn” the stablecoin—removing it from circulation—by exchanging TerraUSD for $1 worth of new units of Luna. That action reduced the supply of TerraUSD and raised its price.

Conversely, when TerraUSD’s value rose above $1, traders could burn Luna and create new TerraUSD, thus increasing the supply of the stablecoin and lowering its price back toward $1.

Do Kwon,

a South Korean developer, created TerraUSD. The coin launched in 2020 and prior to its collapse had swelled to a size of more than $18 billion. 

What caused TerraUSD to break from its peg? 

Traders said the catalyst for the drop—which began over the weekend of May 7-8 and snowballed the following Monday, May 9—was a series of large withdrawals from Anchor Protocol, a kind of crypto bank created by developers at Mr. Kwon’s firm, Terraform Labs. 

Such platforms are used by digital-currency investors to earn interest on their coins by lending them out.

By early May, investors had deposited more than $14 billion of TerraUSD in Anchor, according to the platform’s website. The bulk of the stablecoin’s supply was parked in the Anchor platform. Big transactions over that May weekend knocked TerraUSD from its $1 value. The instability prompted more investors to pull their TerraUSD from Anchor and sell the coin.

That, in turn, led more investors to withdraw from Anchor, creating a cascading effect of more withdrawals and more selling. TerraUSD deposits at Anchor fell to about $1.6 billion by May 13, Anchor’s website shows.

What did this mean for other cryptocurrencies? 

A reserve fund of about $3 billion in bitcoin and other cryptocurrency resources, owned by the Luna Foundation Guard, a nonprofit co-founded by Mr. Kwon, had been largely depleted amid an emergency effort to maintain the peg for TerraUSD in mid-May, according to the fund’s data dashboard. The fund’s selling of large amounts of bitcoin contributed to a sharp drop in bitcoin’s price earlier this week, analysts and traders said.

As TerraUSD and Luna began falling the week of the selloff, bitcoin also declined, going below $26,000 on Thursday, May 12. 

What happens next? 

Mr. Kwon tried to rally his followers following the selloff of both coins. The blockchain underlying TerraUSD and Luna was twice halted as its network validators seek to stabilize the digital assets.

But both TerraUSD and Luna have fallen sharply from their prior values. Many traders have sold, expecting that the assets won’t be able to rally back to their original levels. And even cryptocurrency enthusiasts say this has shaken their faith.

What are regulators doing?

The episode has also refocused policy makers’ attention on the lack of regulation around stablecoins and the broader cryptocurrency market. As TerraUSD decoupled from its peg May 10, Treasury Secretary

Janet Yellen

renewed calls for Congress to pass legislation to to govern stablecoins.

At the same hearing, Pennsylvania Sen. Pat Toomey, the Banking Committee’s top Republican, expressed an interest in moving quickly on related legislation.

Securities and Exchange Commission Chair Gary Gensler has spoken in the past about potential risks that stablecoins pose to investor protection, illicit activity and financial stability. Mr. Gensler has declined to speak about the recent turmoil in crypto markets.

Paul Kiernan contributed to this article.

Write to Caitlin Ostroff at caitlin.ostroff@wsj.com