What Happened to LUNA

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The Terra blockchain allows users to mint algorithmic decentralized stablecoins. LUNA is the native token on the Terra platform, it serves as a governance token, and it grants holders of the token voting power on the protocol. LUNA also serves as the collateral for minting stablecoins on the Terra blockchain.

TerraUSD (UST) is the most popular stablecoin on the Terra platform. There is currently over 11 billion in supply. UST aims to maintain its peg to the U.S. dollar through a network of arbitrage traders, who mint and burn Terra’s volatile native token, LUNA.

Stablecoins issued by Tether (USDT), Circle (USDC) and Binance (BUSD) maintain the peg to the USD by keeping a combination of commercial paper, cash, fiduciary deposits, and reserve repo notes, and treasury bills in their reserves. The amount in their reserve should always be equal to the USD value of the tokens in circulation.

How UST Works

To mint UST on the Terra blockchain, traders need to burn an equivalent value of LUNA.

For instance, if 1 LUNA equals $10, when it is burned, 10 UST is created.

To maintain the peg, traders are incentivized by profits from trade arbitrage.

From the previous example, if UST is trading at $1.5 (instead of $1), traders can take advantage of this opportunity by burning the 10 LUNA and making 5 UST in profit.

This will effectively increase the supply of UST which leads to a drop in its price bringing it back to its $1 value.

In a reverse case, if UST is trading below $1, traders can burn UST and mint LUNA. This reduces the supply of UST, stabilising its price.

The Crash

The LUNA/UST relationship was a very delicate one. They are both correlated, meaning the events affecting LUNA tend to affect UST and vice versa. On the 9th of May 2022, when UST lost its dollar peg during the crypto market crash, LUNA was brought down too.

It is possible UST holders feared the token losing its peg and started selling it off, traders on the Terra blockchain were unable to keep up with the massive sell-off so LUNA crashed.

UST is currently valued at $0.1238 at the time of writing. Dropping by over 37%.

Source: CoinMarketCap (2022)

LUNA took a heavier hit. It dropped by 100% on the 12th of May 2022 to $0.00913. Puting perspective into this, LUNA once had an all-time high of $119. It was ranked 8th on CoinMarketCap with a market capitalization of $28 billion. Its market capitalization went as low as almost $600 million on the 12th of May. It is currently ranked the 211th with a market capitalization of $1.4 billion.

Source: CoinMarketCap (2022)

The Flaw

The major issue many critics raised when examining the LUNA model was the lack of stable collateralization.

Essentially, a token that is supposed to be stable shouldn't be collateralized by a volatile asset.

It is a recipe for disaster!

Putting this in Tradfi terms, imagine a bank allowing borrowers to use volatile assets like their mobile phones and personal cars as collateral for loans. The bank will ultimately go out of business because the assets used as collateral depreciate rapidly over time. However, there are outliers like limited edition phones and luxury cars but most people wouldn't have access to them.

This is why banks tend to require more stable assets such as real estate, fine art, collectables, insurance policy and jewellery. These are more stable and the bank will be able to recover its funds in the case of a default.

The Aftermath

Do Kwon, the co-founder of Terraform Lab, came out with an action plan to restore the protocol.

In the Terra Ecosystem Revival Plan, Do Kwon proposed for the Tera blockchain to be forked to Terra2. He proposed the validators reset the UST supply to 1 billion units and it should be distributed as follows:

Validators should reset the network ownership to 1B tokens, distributed among:

  • 400M (40%) to LUNA holders before the de-pegging. He suggested they be settled based on the last $1 tick before the de-pegging on Binance. LUNA locked in smart contracts are to be settled too.
  • 400M (40%) to UST holders in proportion to their holdings. He identified them as a priority, and that they would be refunded as much as they can.
  • 100M (10%) to LUNA holders at the last moment of the chain stopping operation. The final marginal traders who attempted to provide stability to the network are to be compensated.
  • 100M (10%) to the Community Pool to provide for future advancements in the chain.

Following the release of this plan, it came under criticism from Vitalik Buterin, the co-founder of Ethereum and Changpeng Zhao, the CEO of Binance.

Vitalik criticized the model of UST, stating that it is inherently flawed and it is not sustainable. He compared UST with decentralized stablecoins such as DAI which is collateralized by actual cash assets held in smart contracts. This is unlike UST which has no cash assets as collateral.

Changpeng Zhao (CZ) criticized the recovery plan issued by Do Kwon. He stated that forking a network doesn't have a positive impact on the native token.

CZ explained a major flaw in the recovery strategy issued by Kwon. He said, “minting coins (printing money) does not create value, it just dilutes the existing coin holders.”

Essentially, minting new tokens will make the value of tokens drop even further as the supply will outweigh the demand.

CZ also questioned the $3.5 billion in Bitcoin held by Luna Foundation Guard (LFG), and that it could be used to back up

Conclusion

The story of UST shows how catastrophic it can be if basic economics is ignored. UST was not collateralized by any assets, its value was backed by the continuous minting and burning mechanism of traders on the Terra blockchain. This is somewhat similar to a Ponzi scheme because there was no asset of real value behind the stablecoin.

The collapse of LUNA is very disheartening as many holders lost all their money in the crash. This event sent shockwaves to holders of all altcoins as LUNA which wasn't a shitcoin collapsed so suddenly, and yet popular shitcoins haven't experienced such decline since their inception.

Ultimately, I believe the crypto sector would get through this. There are lessons to be learnt from the event and hopefully, we won't see a repeat of such.

References

  1. What Is Terra? The Algorithmic Stablecoin Protocol Explained
  2. Terra Ecosystem Revival Plan
  3. Vitalik and CZ Have Some Thoughts on Terra’s Demise

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