Terra Crash: Explained (& How to Claim Losses)
Posted On July 11, 2022
The Terra crash is a historic event for the entire crypto industry. An event that we’ll remember for years to come.
It set many examples, taught many lessons and unfortunately, cost people millions of dollars.
Terra (LUNA), once trading for more than $80 per unit just a month ago, is now trading for merely a few cents. And it’s no different with TerraUSD (UST). Some people are calling this the “crypto’s version of the 2008 recession”.
But how did it lead to all of this? When and where did it all start? What exactly went wrong? And most importantly, what to do now? How to mitigate your losses?
We’ll answer all these questions and more in the article, so stick till the end.
Here’s what you’ll learn in the guide:
- How does LUNA-UST work?
- What exactly went wrong?
- The aftermath
- How to mitigate your losses
- What does this mean for the future of crypto, especially stablecoins?
How Does LUNA-UST Work?
Before explaining what went down, you must understand how Terra works because it’s not as straightforward as you might imagine it to be.
Terra is an algorithmically-governed public blockchain protocol. Though it has many products, it’s mainly famous for TerraUSD (UST), the stablecoin, and LUNA, its native cryptocurrency used for governance, mining rewards, volatility absorption and transaction fees.
How UST Works
If you know how stablecoins work, you would know that most stablecoins are pegged to a fiat currency or some other assets. In the case of UST, it’s pegged to the US dollar, meaning its value always stays at $1.
But unlike other stablecoins, UST isn’t backed by actual US dollar reserves.
What does it mean?
Well, stablecoins backed by actual reserves can and must, in theory, pay off every single coin holder in case they sell it all off at the same time.
UST, on the other hand, is backed by algorithms, coding and sheer belief, which some are now calling the biggest flaw in its mechanism that led to its downfall. More on this later.
The Relation Between LUNA and UST
Saying UST is backed by algorithms and codes is a little too reductive and oversimplifying it.
Its actual mechanism is much more complicated than that.
Let’s look at an example of how you would buy 100 UST ($100) to understand how it really works.
To buy 100 UST, you would first have to buy $100 worth of LUNA coins. Then, you’ll essentially burn that $100 worth of LUNA to mint 100 UST.
This decreases LUNA’s supply, creating scarcity and driving its price up while at the same time keeping UST’s value stable. And the mechanism is such that the users of UST and LUNA are incentivized to participate in it.
But who knew that this was a double-edged sword? That the same mechanism responsible for its growth will also become the reason for its downfall.
What Caused the Terra Crash?
It all started with Anchor, a lending protocol that some people are now calling a Ponzi scheme. Supposedly, the Anchor protocol was offering 20% APY on UST. Naturally, this drew many people to lend their UST on the platform.
The Domino Effect
The domino effect started on May 7, 2022, when a huge $2 billion UST withdrawal was made on Anchor, followed by an immediate sell-off.
There are speculations that this was done by a crypto whale (or a group of whales) with malicious intent. There’s no evidence to prove this yet but what followed was a total disaster for Terra.
Due to its self-stabilizing mechanism, LUNA’s supply went from 725 million tokens on May 5 to 7 trillion tokens on May 13. The massive increase in its supply caused its price to go down. Things got even worse when people started panic-selling due to the rapid downfall, further dragging the price down.
This is what we typically call a death spiral.
In an attempt to get things under control, the Luna Foundation Guard spent nearly $3.5 billion in Bitcoin reserve to try and defend the peg but failed.
And that’s how the Terra crash went down.
The Aftermath of the Terra Crash
As of writing this article, both LUNA and UST have lost almost all their value. It’s pretty much a ghost chain now.
People use stablecoins as an alternative to fiat currency for trading and investing. Instead of triggering a tax event every time they buy or sell cryptocurrencies, they simply swap them with stablecoins. That’s how people lost thousands and even millions of dollars in Terra when it crashed.
Unfortunately, some people lost their entire life savings. People all over the world started tweeting about their losses and the impact they had on their finances and mental health.
The impact was felt by other stablecoins as well. Due to the panic and fear surrounding the crash, people started selling off other stablecoins as well, though they quickly recovered from it.
Even the big cryptocurrencies like Bitcoin and Ethereum felt the impact, as right after a week of the crash, these cryptocurrencies were trading at some of the lowest prices since the January dip this year.
Basically, the ripple effect traveled all through the crypto industry, including major crypto exchanges.
Even though there’s no way you can get even a fraction of what you may have lost back, you can still use your losses in a smart way.
Let’s get the most obvious question out of the way first.
Can you claim casualty losses for the Terra crash?
The answer is NO. Let us explain why.
After the Tax Cuts and Jobs Act, passed in 2017, most forms of casualty losses are non-deductible on Form 4684 except for any casualty that qualifies as a federally declared disaster.
Long story short, you can’t claim casualty losses on the Terra crash. If you want to learn more about casualty losses, check out this guide on lost or stolen crypto taxation.
So, if you can’t claim casualty losses, what can you do?
The best course of action from here on now is to dispose of all your LUNA and UST tokens, realize losses and use them to offset gains. Check our guide on tax-loss harvesting to know more about this.
A Ray of Hope?
The founder of Terra, Terra Do Kwon, announced a hard fork, which may help recover their lost money. But it’ll take time. You can wait for it if you have faith in Terra, but the market sentiment is against it.
The Future of Crypto and Stablecoins
Many people believe that the entire industry will witness a ‘crypto winter‘ where prices will stay low for months to come.
The Crypto Market
Despite all the drama, panic and fear, most cryptocurrencies, especially the major ones, proved to be more resilient than expected. Though not all cryptocurrencies went back to their pre-Terra crash prices, most of them are recovering pretty well and fast.
This event gave skeptics all the ammo they needed to demand stricter regulations and oversight by the government on crypto. Whether valid or not, it’s worth considering that this could be a warning sign. We should take this event seriously, study it and make sure it doesn’t happen again.
And that may include involving the government more than most people are comfortable with.
However, it’s still a developing story. Yes, people have lost their hard-earned money, but we’ve yet to see how it all unfolds.
On an optimistic note…
Events like this help us find flaws and issues in the technology that needs fixing in order to make it more robust. As sad and unfortunate as it is, this event will only help us improve the technology.