Home collateral What lessons can we learn from Terra’s LUNA/UST collapse?

What lessons can we learn from Terra’s LUNA/UST collapse?


The recent sell-off in the crypto market was highlighted by the failure of Terra LUNA/UST, which left investors in shambles, wiped out tens of billions of dollars of value in days, and will most likely induce a political response. strict when it comes to stablecoin regulations. close future.

TerraUSD, or UST, was designed to be an algorithmic stablecoin – a specific digital asset pegged to the value of one US dollar. To maintain their value, algorithmic stablecoins are backed by a set of smart contracts on the blockchain, also called a “protocol” that require collateral in the form of other digital assets to be placed in the system in order to issue algorithms. stablecoins. .

Unlike reserve-backed stablecoins – which rely on a third-party organization to manage the monetary supply and maintain adequate reserves, usually in the form of US Treasury bonds, cash equivalents or other traditional assets – Algorithmic stablecoins do not rely on a third party but rather on programmable software to control supply and maintain adequate collateral.

The peculiarity of the UST, which made it very susceptible to a bank run, was that the liabilities of the UST were mainly backed by LUNA, a sister cryptocurrency native to the same underlying network – the Terra blockchain. Every time someone wanted to create a show of UST, a certain amount of LUNA had to be taken out of circulation (burned). And vice versa, every time someone burned UST, they created LUNA (minted) tokens.

Terra Economy: The LUNA and UST Relationship

Terra’s algorithmic stablecoin and its reserve currency LUNA worked in an intentionally structured and symbiotic way. Did this amount to a Ponzi scheme? Consider built-in incentives.

From March 2021, the Anchor protocol – a decentralized protocol native to the Terra blockchain – offered between 18 and 23% interest rate on UST filings, and naturally it started attracting a lot of depositors. The deal seemed almost too good to be true: all everyone had to do was get their hands on UST and deposit it on the Anchor protocol for a return of around 20% on the dollar.

As the market demand for the UST increased, the circulation of the stablecoin increased and for this, as explained earlier, the burning of LUNA tokens was necessary. This created upward price pressure on LUNA for several months – its price rose from US$6.50 to a high of US$116 in just over 13 months, a 16x increase. But with the increase in stakes (depositors) on the Anchor protocol, the passive interests of the Terra blockchain have skyrocketed in absolute value.

Luna Foundation Guard, a Singapore-based nonprofit created to facilitate the Terra ecosystem, had to repeatedly inject capital into the Anchor protocol so that it could cover debts and pay out the return to depositors.

It was not a stable system initially, but as long as the adoption rate of UST was coupled with the rising price of LUNA, there was theoretically enough collateral, even if it consisted of a single underlying asset volatile and poorly constructed.

However, when the price of LUNA started to drop sharply, the real chaos began. All the dynamics that followed can be simplified as follows:

  1. People take out (burn) UST and get (mint) LUNA;
  2. They sell LUNA to other stablecoins like USDC, USDT, and DAI to get out of the Terra ecosystem completely;
  3. The price of LUNA drops;
  4. The cycle repeats and grows stronger as panic and uncertainty spread further.

When enough people are engaged in this cycle, the time comes when the UST’s liabilities exceed its assets and a “bank run” begins.

At this point, market speculators also play their part. Seeing the system shaking, they add more fuel to the fire by starting to bet against the Terra ecosystem – shorting out both UST and LUNA. Somewhere at this point, the UST begins to unanchor significantly from the value of 1 USD.

Enter the death spiral

And here comes the infamous death spiral. Arbiters are beginning to exploit UST’s interleaved mint/burn mechanism. The relationship between the two digital assets is programmed in such a way that 1 UST can always be exchanged for 1 USD of LUNA, regardless of the current price of LUNA.

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So, whenever the UST is below $1, it is economically feasible to buy it back for $1 in LUNA and instantly sell LUNA to complete the arbitrage. Unsurprisingly, that is exactly what happened. It drained all collateral from the system, demolished the price of LUNA, and drained the majority of deposits from the Anchor protocol. The number of UST filings rose from around 14 billion on May 6 to 1 billion on May 19, a drop of 93% in less than two weeks. It was truly a storm of biblical proportions.

Additionally, the supply of LUNA is elastic, which means that when the price drops, more LUNA is released to help maintain the active/liability balance of the UST. The price drop, however, was so severe and rapid that elasticity was a bug and not just a feature in this particular case and completely destroyed the value and recoverability of the underlying LUNA.

Following the withdrawal of the UST, the circulating supply of LUNA dropped from 345 million to 6.5 trillion (yeah trillion) coins, making it essentially worthless. LUNA, now renamed Terra Classic, or LUNC, now has a much lower price $0.0001according to CoinMarketCap.

Could the collapse of Terra have been predicted?

Should the world have seen the LUNA/UST crisis coming? Without question, yes. The transparent nature of blockchain and algorithmic stablecoins also provides anyone curious enough with all the tools to see and understand the circulating supply pattern, mint/burn cycle, and collateralization mechanisms. Even with Terra, there were plenty of whistleblowers publicly campaigning for the impending doom that is approaching, but human psychology has triumphed over all.

Even though you were skeptical at first but continued to earn a 20% return on your assets, after a while, probably subconsciously, you started to minimize the red flags and focus on the positives. At least until shit hits the fan.

Lessons to be learned

The tragic case of Terra, which could be the biggest wealth destruction event in the crypto market, does not indicate that there is “no low risk in crypto”, but rather shows that the market is still in its development phase, and what we have witnessed can be classified as the adaptation of the crypto market to the changing environment.

TerraUSD is a peculiar and poorly designed stablecoin, and this is the main reason why this experiment ended badly. Since then, other stablecoins and their respective collateralization mechanisms have also come under market pressure. On May 12, even Tether (USDT) – the largest centralized stablecoin, experienced a 6% unpeg event that lasted around four hours.

Some stablecoins have been completely #rekt, some have lost their peg for a while, and some have come out unfazed, like USDC or DAI. The lesson here is that fundamentally sound systems prevailed and acted as safe havens during the overall market sell-off. It will not go unnoticed by market players, and confidence in them will only grow.

Each upcoming competitor will have to earn their place among the stablecoin elite. They will be tested, as they should be, and the fittest and best-designed ones will survive, ultimately making the whole ecosystem more efficient, safer, and more resilient.