Terra Luna: is UST and LUNA crash the crypto Lehman Brothers?


I would like to try to explain what happened with Terra — Luna. For sure, this is a high -level analysis, and deep understanding on the causes that have rushed the largest ecosystem failure in the recent crypto history, will involve more info and study.

In any case, 28 Bn drop in the last 48 hours (2012 Greece financial assistance was around 32 Bn, to illustrate the magnitude of the crisis that Terra is going through), and overall 37 Bn, is large enough to make it worth to try to explain it.

But what is Terra, Luna and UST?

UST is an algorithmic stablecoin that works very well upwards and poorly when the peg is lost. How do we know this? Because no matter what the math models say, it has not been able to maintain the peg, and that adds to another recent use case (Iron Finance — Titan crash), that is also analyzed in this thread: https://pabloam89.medium.com/iron-finance-collapse-first-defi-crash-1a31b4559805.

It has developed an ecosystem — called Terra — that is based on aforementioned UST stablecoin as a payment railway, and LUNA, the native token that is either minted or burned to ensure the peg in 1 USD.

The main dApp that has been deployed in Terra protocol is Anchor (beyond Mirror), a savings protocol that gives the users around 20% APY to the users. This APY, which is top leader in the market, is partially funded by the Luna Foundation, in the sense that they cover the APY that is organically generated by Anchor itself until reaching the 20% APY. The business model works by staking those UST that have been previously locked in Anchor in Lido (a POS staking protocol), supporting the remaining APY as a mechanism to attract users.

Terra’s vision, which tried to develop a dynamic ecosystem leveraged on the UST adoption, didn’t work as expected — because primarily, most USTs (reached 85%) were locked in Anchor — and that’s the reason why they were looking for other ways, such as Curve’s 4Pool.

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The reasons of the fall

Once we have explained the Terra basics, let’s go into a downtrend example that illustrates the negative effects that the peg loss generates. If UST falls below 1USD, in theory, the stabilization mechanism allows you to exchange your UST, which is for example at 0.95 for LUNAs, worth 1 USD. Those USTs are burned, and therefore, as the money supply drops, the UST price should rise to 1 USD. And intuitively speaking, it makes sense, since I am going to recover the 1 USD worth in LUNAs, and I am getting rid of my 0.95 USD UST, which is getting burned, thus reducing the UST supply, thus increasing UST price.

Nevertheless, in this case, the fall has been very strong, and the natural stabilization mechanism hasn’t been strong enough to hold the drop. Basically, on May 8th, around 280M UST were sold, together with the short positions maintained, triggering an additional massive selloff that unbalanced the peg.

And we have seen that no users wanted to obtain LUNAs by giving USTs, for two reasons: first, when LUNA token price has started falling, UST value to 1 USD couldn’t be recovered (the stabilization mechanism wasn’t working). Secondly, the use cases of LUNA are not clear — they are utilized to pay fees for using the Terra network, but it doesn’t allow to participate in Luna’s governance -, so it’s difficult to foresee its adoption/acquisition trend in a bearish scenario, especially when the payment network wasn’t used at all by other dApps.

In this sense, UST token holders, who don’t participate in Terra’s governance, and see continuous LUNA token depreciation didn’t want to get LUNA, even though the UST price was falling. And as nobody wanted to give their UST for LUNA, this has accelerated the fall speed of both LUNA and UST (when the mechanism cannot be triggered, the vicious circle is unstoppable).

And finally, the buy wall of 10 Bn in BTC that Terra wanted to implement to sustain the peg in case of collapse, has not been deployed, because the market has apparently shortened the USTs just before creating it (there are some tweets explaining the 1.5 Bn plan of lending 750M worth of UST for BTC, and 750M loan to some trading OTC firms to acquire BTC). The goal was to turn Terra into a fractionally algorithmic stablecoin (FRAX type), since the Luna Foundation recognized fragility in the ecosystem, but there was no time for that.

Some takeaways from this hard lesson

In conclusion, it looks like stablecoins cannot rely on pure algorithmic mechanism to resist heavy volatile scenarios, but they need to structure around tangible collaterals that ensure a floor for stablecoins token holders when organic stabilization mechanism cannot be implemented. And also, it shows that the crypto markets are able to erase projects which cannot sustain organically through their system of incentives, as the subsidized mechanism or other types of assistances are not part of the current crypto system.