DeFi

$119.18 to $0.05 in a month - LUNA and UST Disaster Explained

Rahul Kaushik
.
Web 3.0 Research Analyst
Written by
Rahul Kaushik
Published on
May 30, 2022
Read time
4 Min Read
Category
DeFi
Nov 15, 2022

The crypto markets are no stranger to crashes. The world has seen a variety of major events, from the DAO hack in 2016, to the Mt. Gox fiasco in 2014, and most recently with Bitconnect's collapse. However, one crash that caught everyone by surprise was the UST and LUNA shipwreck.

Unless you've been living under a rock, you've probably heard about Terra Luna's recent debacle - Terra USD (UST), lost its peg to the dollar, sending the price of LUNA into a downward spiral resulting in a bloodbath across the crypto ecosystem.

LUNA dropped from an all-time high of $119.18 in April to $0.05, a drop of more than 95%!

The crypto market, as we all know, keeps us on our toes daily, but what was unusual even in the crypto market was the rapid decline of the Terra Luna ecosystem and its algorithmic stablecoin - UST.

Let us first define UST before we understand what caused this unimaginable crash.

What exactly is UST, and how does it work?

Terra's UST is an algorithmic stablecoin, which means that various smart-contract-based algorithms are running in the background to burn/mine LUNA or UST while keeping the price fixed at $1.

Other stablecoins, such as USD Coin (USDC) and Tether (USDT), are fiat-backed, which means they have $1 in reserve for every token issued. That is, you can exchange 1 USDT or USDC for a physical dollar.

One of the first signs of trouble for Terra came last Saturday, May 9th when UST deposits on Anchor began to dry up.

Anchor is a money market protocol of the Terra ecosystem.

It enables stablecoin lending and borrowing. Lenders can borrow stablecoins by depositing them on the platform and earning interest on them. Borrowers can then use stakeable assets as collateral to borrow these stablecoins.

Anchor promises users who deposit their UST on the platform market-leading annual yields of up to 20%.

How does Anchor achieve a 20% yield?

Arbitrage at its finest. The system is intended to capitalize on supply and demand.

Traders can exchange LUNA (the governance token) for UST at a guaranteed price of $1 – regardless of the current market price of either token. This means that if the price of UST rises above $1 due to increased demand, traders holding LUNA can make a profit by exchanging $1 of LUNA for one UST token (which is worth more than $1 due to increased demand).

To ensure that this process runs smoothly, a portion of the LUNA is burned and permanently removed from circulation. The remainder is placed in a community treasury to help Terra expand its services and improve its ecosystem.

Burning a percentage of LUNA tokens reduces the total number of tokens in circulation, making them scarcer and thus more valuable. By issuing additional UST tokens, the existing tokens in circulation are diluted, bringing the overall price back down to $1.

If demand for UST falls and its price falls below $1, arbitrageurs (traders who profit from market inefficiencies) will sell UST for LUNA (because it is worth more due to scarcity) until the balance is restored.

Let's take two simple scenarios to understand this.

Scenario 1: UST falls to $0.90

Arbitrageurs sell one UST (currently trading at $0.90) to purchase one LUNA (worth $1) -> sell LUNA for one dollar -> profit of $0.1.

Scenario 2: UST rises to $1.5

Arbitrageurs sell one LUNA (worth $1) to buy one UST (worth 1.5$) -> Sell UST for $1.5 -> $0.5 profit.

When the price of UST falls below $1, users sell 1 UST for $1 worth of LUNA, and 1 UST is burned to restore the price to $1.

When the UST exceeds $1, users sell $1 worth of LUNA for 1 UST, and that 1$ worth of LUNA is burned to return the price to $1.

This was how the UST remained pegged to the US dollar.

How did it come crashing down?

The 20 percent yield on the anchor protocol was the enticing carrot for all UST demand.

In a world where fixed income products are barely beating inflation, a 20% yield looked appealing, resulting in an influx of capital from investors.

This massive demand to buy UST and earn interest was also one of the factors driving up the price of the governance token LUNA.

Critics claimed that this artificially inflates demand and that the rate is unsustainable. The fear was that if interest rates fell, investors would move their funds elsewhere, resulting in a loss of liquidity and making it difficult for people to sell their UST.

Furthermore, a sharp drop in UST demand or extreme LUNA price volatility could cause it to lose its peg, which would be disastrous for the entire ecosystem and investors.

This is exactly what happened: a cryptocurrency bank run.

On May 7th, after months of collecting 20 percent APY in UST rewards from Anchor, users began withdrawing their tokens and cashing out.

Before UST began its decline late on Saturday, May 9th, Anchor housed 75% of UST's total circulating supply. This amounts to $14 billion in UST out of a total circulating supply of $18 billion.

The massive dilution of UST into the circulating supply caused UST to lose its peg to the dollar.

To combat this, on May 9th, LFG (Luna Foundation Guard) announced a $750M BTC loan to trading firms to protect the peg, as well as another $750M loan to buy BTC to support the Terra ecosystem.

However, both of these attempts were unsuccessful, and UST's peg to the dollar continued to deteriorate, falling as low as $0.2 at the time of writing.

That isn't all. The entire Terra ecosystem was destroyed. Every token dropped by more than 70%.

How did the Crypto community react?

People are feeling the effects of the market's difficult times.

Some are distraught...

...While others made fun of it with memes.

What is the path forward?

The unfolding of Terra Luna serves as a reminder of why stablecoins – the foundation of decentralized finance – not only pose a risk to individual traders but also pose a systemic risk to the entire crypto ecosystem if not managed responsibly.

While there is no doubt that the markets will recover and the Web 3.0 world will continue to grow and progress, the LUNA/UST incident is certainly a difficult pill to swallow, at least temporarily.

As Will Clemente put it, "This is crypto's Bear Sterns/Lehman Brother's moment, but here there are no government bailouts."

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Rahul Kaushik

Rahul is a former software engineer who is now a writer. After working as a full-stack developer early in his career, he realized that coding was not his forte and began writing blogs, poetry, and articles for sports magazines. He is always torn between Football and Bitcoin as his first love. In his spare time, he enjoys reading books on economics, startups, and business, as well as educating people on personal finance, cryptocurrency, and Web 3.0 on Instagram.

Rahul Kaushik

Rahul is a former software engineer who is now a writer. After working as a full-stack developer early in his career, he realized that coding was not his forte and began writing blogs, poetry, and articles for sports magazines. He is always torn between Football and Bitcoin as his first love. In his spare time, he enjoys reading books on economics, startups, and business, as well as educating people on personal finance, cryptocurrency, and Web 3.0 on Instagram.

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