UST/LUNA meltdown — The full story

Rogerio Rais
Coinmonks

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We have just witnessed one of the largest scale events in Crypto History.
The Fall of UST and the Eclipse of Luna.

For quick context, Terra is a blockchain ecosystem of many different products and intergrated protocols serving multiple use cases, however the main use case is (was) their algorithmic stablecoins and in-payment processing. In this excerpt we’ll cover the rise and fall of one of the most beloved ecosystems, what happened and what happens next.

Context

Terra’s stablecoin algorithm (should the mechanism stay intact) allows their tokens (UST/KRT, EUT) to be pegged 1:1 to the US dollar, the Korean won and the Euro. The main idea behind these stablecoins was to provide a decentralized alternative to traditional currencies, as well as provide a faster, cheaper and simpler way to transact in DeFi.

Luna, Terra’s native coin is at the heart of the ecosystem. Luna is used to maintain the value of UST at $1 worth, as well as network fees, which we won’t go into here.

Mechanism

The Terra protocol uses basic market forces of supply and demand to maintain the price of UST. A mint and burn mechanism was implemented, whereby when the price of UST is high relative to the 1:1 peg, supply is too low, and demand is too high. The protocol incentivizes users to burn Luna and mint UST. The new supply of UST makes its ‘pool’ larger, balancing supply with demand. Users mint more UST from burned Luna until UST reaches its target price (1:1 peg) The Luna pool gets smaller in this process, increasing the price of Luna. This process is called UST Expansion.

Conversely, when the price of UST is too low relative to its peg, supply is too large and demand is too low. The protocol incentives users to burn UST and mint Luna. The decrease in UST’s supply causes scarcity, and the price of UST increases. More Luna is minted from burned UST until it reaches its target price (1:1 peg). The Luna pool increases and lowers in price — Contraction — which is precisely what has happened with the great decline of Luna — The supply has increased exponentially. As has demand.

The Death Spiral

This was something on the cards since day one. It may have been a case of Terra’s community ‘turning a blind eye’ to it. Or an echo-chamber of positive reinforcement, profit, and exuberance. After all, both UST & Luna reached the top 10 in market cap with a combined market cap of $50 Billion + at their heights!

— “Algorithmic stablecoins are inherently fragile. These uncollateralized digital assets, which attempt to peg the price of a reference asset using financial engineering, algorithms, and market incentives, are not stable at all but exist in a state of perpetual vulnerability.” Source: http://www.wakeforestlawreview.com/2021/10/built-to-fail-the-inherent-fragility-of-algorithmic-stablecoins/

The above article argues — “that algorithmic stablecoins are fundamentally flawed because they rely on three factors which history has shown to be impossible to control. First, they require a support level of demand for operational stability. Second, they rely on independent actors with market incentives to perform price-stabilizing arbitrage. Finally, they require reliable price information at all times. None of these factors are certain, and all of them have proven to be historically tenuous in the context of financial crises or periods of extreme volatility.”

In short; including the above 3 factors. UST and Luna’s demise can be factored down to; ‘No net to catch the cascade’, i.e., collateral for support and massive sell pressure on both UST & LUNA inevitably breaking the mechanism.

Both UST & Luna absorbed an incredible amount of capital. A large sell off could unbalance the mechanism (explained below) — Selling UST in substantial amounts de-pegs it, minting Luna, increasing its supply and decreasing its price. Panic sets in both UST & Luna (as they were both heavy invested in) causing massive sell pressure on both. The death spiral. Let us get into the details.

Coordinated attack or inevitability?

The exact details aren’t clear. Whether this was a multi-level economic attack on UST or if it was UST treading on thin ice.

It seemed to have started on Curve Finance with either a $85 million UST-to-USDC swap in the 3-pool, which un-balanced the pool and led to a 50,000 ETH transaction to balance it. Or a purposeful $285 Million dump on Curve by one party.

Rumours spread fast in crypto, leading to a $2 Billion withdrawal from Anchor Protocol (Terra’s leading protocol with $14 Billion in TVL at it’s heights) creating a deviation in the peg to 0.987–0.995 per UST. Fear, uncertainty, and doubt continue to spread across the community leading to increased selling of UST, in-turn putting Luna minting in over-drive.

There are talks of continued UST dumping by the ‘attackers’ which triggered the Luna Foundation Guard to sell their reserve asset, BTC in order to combat the sell pressure. A fight between the bears and the bulls — in real time!

Liquidations, Shorting and continued sell pressure on both Luna & UST was just too much to bear, literally… And Do Kwon, the Terra founder came to twitter (Albeit very late in the communities perspective) to say “Before anything else, the only path forward will be to absorb the stablecoin supply that wants to exit before UST can start to repeg.”

This was too little too late and did not instil confidence. The bear/bull fight continued in the interim with the bears winning — at extraordinary scale. One of the largest capitulations in crypto history!

At the time of writing, UST is trading at $0.11c (-91%) and Luna at $0.00003749 (-99.80%) per coin. An incredibly sad day for all of crypto — as failure of such magnitude is hard to accept, especially when there are Billions of dollars involved and multiple thousands of people losing fortunes overnight.

What next?

For one, it’s important to note that the Terra ecosystem is ‘rich’ with innovative protocols, intelligent individuals and a once flourishing community. What will happen to these three components is yet to be seen.

The Terra blockchain had officially halted at block 7607789 and then resumed block production 12 hours later. “Validators have decided to disable on-chain swaps, and IBC channels are now closed. Users are encouraged to bridge off-chain assets, such as bETH, to their native chains.” Source: https://twitter.com/terra_money/status/1525095111389945857

The initial proposal seems to be, the removal of Terra Form Labs, fully collateralizing UST and drafting new mechanisms for Luna. This is likely to be too little to late for the ecosystem, unfortunately, as most will have lost complete trust in the system.

Conclusion

Crypto is very-much trust based. This event has affected the entire industry and with many retail investors heading out the exit door, Crypto — Natives searching for answers and regulators likely to start honing down — there’s no clear direction. What do you think happens next?

All we know is that in times of crisis, massive lessons will be learned. Don’t invest more than you can afford to lose, never bet on one ecosystem/coin or token, diversify your holdings and many, many other lessons.

Stay safe out there.

Regards, Rogerio.

Written by Rogerio Morais, Project Coordinator at Sheesha Finance.*

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Rogerio Rais
Coinmonks

Writes about Cryptocurrency, Web3 & Economics.