Wow. What a week it’s been. This sad and unfortunate unravelling of LUNA will surely sit in the crypto history books as one of the most dramatic events. Honestly, I am still at a loss of words to see the speed it has fallen at, and really sad for people that had built up a large amount of their savings and net worth in both LUNA and UST - especially when UST was supposed to be a safe stable coin.
Not entirely sure what the future holds, as in my opinion the only way to sort this out is through a massive cash raise bailout, but let’s take a look at what went down.
Understanding the Terra Protocol: LUNA - UST
As highlighted in the protocol documentation, the Terra blockchain is primarily for the creation of algorithmic stable coins:
“The Terra protocol is the leading decentralized and open-source public blockchain protocol for algorithmic stable coins. Using a combination of open market arbitrage incentives and decentralized Oracle voting, the Terra protocol creates stable coins that consistently track the price of any fiat currency.”
It consists of two tokens - LUNA and TERRA (UST in this case):
“Terra: Stable coins that track the price of fiat currencies. Users mint new Terra by burning Luna. Stable coins are named for their fiat counterparts. For example, stable coin denominations include TerraUSD or UST.
Luna: The Terra protocol’s native staking token that absorbs the price volatility of Terra. 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. The more Terra is used, the more Luna is worth.”
For simplicity of article, will refer to the USD stablecoin UST instead of Terra moving forward.
How the Protocol is Supposed to Work
Stable coins are the main feature of the Terra protocol: crypto assets that track the price of an underlying currency. In this case, referring to UST. As a digital form of currency, UST can be used just like fiat currency with blockchain’s added benefits: an unchangeable public ledger, instant transactions, faster settlement times, and fewer fees.
Stable coins are only valuable to users if they maintain their price peg.
The protocol relies on basic market supply and demand to maintain the price of UST:
Supply Low - Demand High - UST price increases
Supply High - Demand Low - UST price decreases
The protocol is supposed to algorithmically ensure the supply and demand of Terra is always balanced, leading to a stable price in UST.
Enter Terra Pools:
“Imagine the whole Terra economy as two pools: one for UST and one for LUNA. To maintain the price of UST, the LUNA supply pool adds to or subtracts from UST’s supply. Users burn LUNA to mint UST and burn UST to mint LUNA, all incentivized by the protocol’s algorithmic market module.”
Supply Low - Demand High - UST price increases:
Protocol incentivizes to burn LUNA and mint UST
Supply of UST increases, increasing UST pool
Supply balances with demand
Users mint more UST from burned LUNA until the UST reaches $1
The LUNA pool gets smaller in this process, increasing the price of LUNA.
Example: “If 1 UST is trading at 1.01 USD, users can trade 1 USD of Luna for 1 UST. The market burns 1 USD of Luna and mints 1 UST. Users can then sell their 1 UST for 1.01 USD, profiting .01 USD through arbitrage. This arbitrage continues until UST price falls back to match the price of USD.”
Supply High - Demand Low - UST price decreases:
Protocol incentivizes to burn UST and mint LUNA
= Supply of UST decreases, decreasing UST pool
= Supply balances with demand
= Users mint more LUNA from burned UST until the UST reaches $1
= The LUNA pool gets larger in this process, decreasing the price of LUNA.
Example: “If 1 UST is trading at .99 USD, users can buy 1 UST for .99 USD. Users then trade 1 UST for 1 USD of Luna. The swap burns 1 UST and mints 1 USD of Luna. Users profit .01 UST from the swap. This arbitrage continues, and UST is burned to mint Luna until the price of UST rises back to 1 USD.”
“Luna is the variable counterpart to the stable asset Terra. By modulating supply, Luna’s price increases as the demand for stablecoins increases.”
What Can Go Wrong in All This?
The theory of how it works sounds brilliant and great, but historically there has not been any kind of successful algorithmic stable coin without collateral.
UST Demand
UST demand mainly comes from Anchor, which is a lending protocol on Terra that offers ~ 20% APY. This demand has driven up the price of LUNA (as explained above) over the years. The problem comes when the lending demand is significantly greater than the borrowing demand. The only way to maintain these yields is by injecting capital.
This leads to the multiple questions:
What happens when the rates can’t be sustained?
How can you sustain 20% with ever-increasing UST demand?
What happens if rates fall and users want to pull out their UST?
What happens if there is a dramatic decrease in demand for UST?
What happens if LUNA price volatility gets extreme?
What happens if the UST loses its peg?
Terra moved away from the original promise of algorithmic stable coin into building reserves to back the protocol. This indicates that they were unsure if it would sustain itself in market conditions as it was originally set out to do. Reserves could then be used to maintain peg in extreme times. Terra made it public that they would be buying billions of $ in BTC as reserves for the protocol.
More questions:
What happens when the reserves significantly fall in value while having to sell the reserves in order to maintain the UST peg?
What happens in a wide-sell panic where the LUNA-UST arbitrage is not something the market is willing to use?
You can see where this could go wrong:
Crypto volatility
Large withdrawals of UST on Anchor - lower demand, lower rates
Heavy selling of UST
UST loses $1 peg
People want out
Pools get emptied
LF required to sell reserves in an already bleeding market to try to re-peg
More panic
Greater arbitrage opportunity between LUNA-UST mechanism as peg falls further
More LUNA selling
More panic, more people want out
UST greatly de-pegged with billions of UST now wanting out
So What Happened?
From what I’ve read on Twitter, it seems to be an orchestrated attack. We are already in a bear market with some extreme selling pressure outside of LUNA - all crypto and equities have gone through extreme selling in the past couple of weeks. Here is what I have read about the alleged attack:
Apparently someone borrowed 100K bitcoin, and then picked up a large amount of UST with that.
In the midst of the crypto selling happening, they proceeded to dump more BTC on the market (thereby entering a BTC short as it was borrowed). This obviously sent BTC price down further than where it was
With some of the original BTC borrowed, they had taken a large amount of UST as well, which they then proceeded to also sell, creating a de-peg of UST.
When the peg of UST strays a little too far from $1, it becomes more and more difficult to fix as liquidity pools dry up, demand drops, and people look for an exit.
This forces Luna Foundation to tap into their recently purchased BTC reserves in order to deploy capital and push up the UST peg back to 1.
With such heavy selling pressure, and the arbitrage mechanism of LUNA-UST in de-pegs, LUNA keeps selling off. The peg reaches lows of $0.5 on the dollar at a certain point because once it unravels, it unravels. Technically, this leaves an arbitrage opportunity between LUNA-UST that could potentially drive LUNA down to 0. In the midst of this:
LUNA holders have lost about 99% of their value.
UST holders have lost about 50% of their value.
Prices of both LUNA and UST continue to fall at the time of writing this.
It is truly an unfortunate tail of events that has caused people billions of $ in savings and investments, both holders of LUNA and UST which was supposed to be a stable coin. I am still in awe and shock as I write this, and feel extremely saddened for all the people impacted by this.
A Bailout?
Is there a solution? I honestly don’t see how there can be a solution in the near term. Something like this will take time to fix, if it manages to get there. Right now, technically speaking LUNA could tumble down to 0 as an attempt to re-peg happens. The bear market does not help either.
In addition to this, with over $5 billion in UST by holders that did not get a chance to get out, and are probably waiting for the time that they can, the Luna Foundation would need an incredible amount of capital to stabilize the peg. Once that is done, then perhaps LUNA can stabilize and start slowly finding its way back into value.
Then there is the question of how the community still trust it afterwards? Will there be demand for UST? Without UST or other stable coins, what will LUNA exist for?
Repercussions
The biggest thing that upsets me is the people that had an incredible amount of money tied into this and have lost nearly everything. That is tough and brutal, and I am sure many are suffering right now. I really do hope there is some sort of solution that will allow them to recoup at least some of that back in due time.
I definitely expect some government officials to be drooling over this. With so many attacks on Crypto and especially stable coins, this is the perfect setup for them to intervene, and do so with force. They now have a case example of why stable coins need government intervention and control and will most likely use this to further remove the decentralization from crypto. Will be watching what happens over the coming weeks/months.
I wish everyone affected the best of luck, and hope this plays out favorably for them.