The Collapse of UST and LUNA
Introduction
On May 7th 2022 the Terra ecosystem had a combined market capitalization of $49B. Over the following week $48B of wealth had evaporated from the Terra ecosystem. In this article we’ll explain the Terra ecosystem, the role stablecoins play in it and what led to the death spiral of Terra.
Terra Ecosystem
Terra is a blockchain that hosts many dApps, and is a competitor to other blockchains like Ethereum and Solana. Within this ecosystem, there are 2 tokens that are highly impactful to the Terra ecosystem — UST and Luna tokens.
Luna Tokens
Below is taken directly from Terra’s website:
‘ Luna is the Terra protocol’s native staking token. Luna is used for governance and in mining. Users stake Luna to validators who record and verify transactions on the blockchain in exchange for rewards from transaction fees.’
UST & Stablecoins
There are 3 types of stablecoins:
1) Stablecoins backed by a fiat currency like USD, where the stablecoin maintains an equal amount of dollars in a bank account
2) Stablecoins backed by cryptocurrency like BTC, where the stablecoin is collateralized by cryptocurrency
3) Stablecoins backed by an algorithm, where the stablecoins peg to $1 relies on an algorithm to regulate the supply and demand of corresponding tokens.
UST is a combination of 2 and 3; an algorithmic stablecoin which is backed by cryptocurrency.
In early May, the Luna Guard foundation held $3B worth of various cryptocurrencies to collateralize the outstanding $18B worth of UST tokens.
Fiat-backed Stablecoin challenges
In 2014, Tether, a subsidiary of digital currency exchange Bifinex, issued the world’s first stablecoin, USDT, which is 1:1 pegged to the US dollar. This means that for every USDT you issue, you have to deposit one dollar in your bank. Following the USDT is the stablecoin USDC issued by Coinbase and Circle in 2018 that exists in the same way.
The biggest challenge in launching a Fiat-backed Stablecoin is maintaining a bank account where the bank is willing to continue to hold the US dollars reliably for many years. Almost all banks around the world are not open to working with a Stablecoin because of the perceived risks associated with cryptocurrency as well as regulators around the world are trying to shut down stablecoins.
Therefore it’s extremely difficult to launch a fiat-backed Stablecoin, and that’s why only a few fiat-backed stablecoins exist. This is also why launching a crypto-backed or algorithmic stablecoin is so attractive.
“You don’t need to ask permission to launch a crypto-backed or algorithmic stabelcoin”
Stablecoins are essential to the crypto community as they are widely used in powering crypto exchanges that do not have access to bank accounts. Even though it’s extremely risky, this is why so many people are trying to launch crypto backed or algorithmic stablecoins.
Basic rules of how LUNA-UST work:
- One UST = $1 worth of Luna. Meaning, if the price of Luna is $1, you can exchange for one UST, and if the price of Luna rises to $100, you can exchange for 100 USTs.
- UST and Luna are in a “two-way destruction and casting” relationship. That means, when you trade Luna for UST, there is one more UST for one dollar less Luna on the market, and when you trade UST for Luna, there is one less UST on the market. Supply increases and prices decrease, and supply decreases and prices increase.
- UST is minted by Luna, and Luna plans to issue a maximum of 1 billion coins.
Anchor protocol
The Terra project party has established a project called Anchor in 2020. The Anchor Protocol works as a bank that provides UST deposit and loan business. This kind of thing similar to a bank actually exists on other chains like Ethereum. The only difference is that Anchor gives an annualized rate of return on fixed deposits of up to 20%.
How did the 20% guaranteed income of Anchor come from? In fact, it is similar to the logic of the bank in reality: the interest paid by the lender + the investment income, and the investment income comes from the collateral Luna and Ethereum. However, in order to attract attractive loans, Terra has adopted various incentives to keep the loan interest rate very low, so this part of the income is very small. In addition, in the case of the poor secondary market this year, the income from collateral investment is far from reaching 20%.
What if the 20% interest rate promised before is not met? Just use the reserve fund in the foundation to make up. From last year to this year, Terra has replenished the reserve fund many times. In February of this year, Terra founder Do Kwon once again launched a vote to inject a reserve fund of 300 million US dollars.
But the problem is that the reserve fund is almost burned out. According to calculations, the Anchor reserve is expected to be completely depleted in June, and it is imperative that deposit yields drop by then. Just imagine, when the deposit rate of a wealth management product suddenly dropped from 20% to 5%, would you still want to keep your money there? Naturally, I want to quickly take out this money and exchange it for other more stable assets. And when a small group of people start doing this first, and there are signs of instability in the UST price, panic starts.
The collapse of LUNA
On May 8, Terra withdrew 150 million UST from the pool due to a new program, causing a brief dip in UST liquidity. At this very moment, the big institutions started a massive UST sell-off plan, which resulted in an outflow of $2 billion in UST from Anchor that day. As a result, a large number of UST suddenly appeared in the market, and the balance of supply and demand was broken, causing the price of UST to start to depreciate from the US dollar. Many people replaced their UST with Luna, which also led to an increase in the supply of Luna and the price from $90. dropped to $60.
On May 9, Terra announced that it would use the reserve bitcoin loan of $750 million to help stabilize UST, but the sell-off still did not end, causing the price of Luna to drop by more than 50%, and the death spiral began.
On May 10, the situation deteriorated further. Nearly US$6 billion fled from Anchor, the price of Luna plummeted by more than 90% to US$10, and UST completely broke off the anchor and fell to US$0.6. But at the same time, a large number of people began to buy Luna.
On May 11, Do Kwon issued an announcement saying that he could not save the market and could only rely on the arbitrage mechanism to help UST recover the price. Luna fell by more than 90% after hearing the news, the price fell below $1, and UST plummeted to $0.3 at one point.
On May 12, Luna continued to plummet by 99%, almost to zero, and the price of UST fell below $0.2.
On May 13, many exchanges delisted Luna and suspended trading, and the Terra public chain was shut down.
On May 14, Do Kwon tweeted that he did not sell any Luna, and the team was sorting out the reserves and usage, and preparing a new proposal to help Luna rebuild. Luna skyrocketed more than 1000 times from around $0.00004.
However, the price of Luna fell back quickly after a few days of “dead cat jump”, currently hovering around $0.00014, while the stablecoin UST fell to less than $0.09.
Luna Foundation Guard Investigation
The Luna Foundation replenishes UST reserves with 28,205 BTC. On May 10th, the Bitcoin address of the Terra ecological non-profit organization Luna Foundation Guard (LFG) transferred 42,530 Bitcoins at 02:34:13, and then transferred 28,205 Bitcoins at 04:34:20. A total of 70,736.3 Bitcoins are held. If we use Breadcrumbs.app tool to follow these Bitcoins, we will find that BTC was subsequently moved to a single account at centralized exchanges like Binance and Gemini:
Conclusion
Most of the market value in the Terra ecosystem was in the UST token ($18B) and the Luna token ($25B), and since UST value is tightly integrated to the Luna token, when UST’s value spiraled it brought down Luna’s value as well.
Algorithmic stablecoins are high risk economic experiments played out with real money, and there’s a graveyard full of failed algorithmic stablecoins, including IronFinance, SafeCoin, BitUSD, DigitalDollar, and NuBits. The reasons why UST’s death spiral caused so much more damage than these previous algorithmic stablecoins are because:
- Terra has done a great job of marketing and building their community of “Lunatics” which helped grow their investor base quickly and to a big scale
- During Terra’s rise the overall crypto industry was in a bull run
- UST’s token value directly impacted Luna’s token value which has a large market cap
Even in 2019 at a crypto conference, this Terra collapse was predicted at a crypto conference:
https://youtu.be/hH8n2vk0yaI?t=13043
As long as more algorithmic stablecoins are launched in the future, more stories like Terra’s rise and fall will continue to happen, and hopefully with much less negative impact.
