LUNA goes bankrupt, $50 billion wiped out

Since May 8, 2022, UST has slightly decoupled and has been running "underwater" for a long time, causing market panic. The whales continued to sell UST, and finally formed a death spiral. The lowest price of UST reached $0.21, and LUNA was wiped out.

The positive feedback mechanism of LUNA-UST determines that when accidental factors cause the market's confidence in it to collapse and UST is unpegged, it has no internal stabilization mechanism to return to the "steady state" and must rely on LFG's expectation guidance or real money to stabilize. Therefore, it is extremely dependent on LFG's "lender of last resort" role and actual "lender of last resort" strength, and is full of uncertainty.

UST is backed by LUNA’s market value, and the two share liquidity. However, UST’s rapid issuance and price-feeding mechanism have accumulated a huge amount of insufficient minting debt during LUNA’s rising cycle, and triggered a death spiral during this falling cycle. LFG may have also realized the problem of price support and introduced BTC to strengthen liquidity, but the market did not give UST time.

From the UST crash, we can see that the biggest risk of Suwen is user confidence. Once users lose confidence and start panic selling, it is very easy to trigger a death spiral. The main reason for users to lose confidence is that Suwen’s collateral is insufficient. The collateral of UST is essentially LUNA. It is neither as high-consensus as Dai’s collateral ETH, nor as stable as Frax’s collateral USDC in purchasing power. Terra originally had a glimmer of hope, but Do Kwon’s wrong decision caused the market value ratio of UST/LUNA to expand rapidly, dragging both into an abyss of no return.

Contents

1 LUNA-UST dual-currency helix

2. The amount of UST to be “digested” is huge

3. The market value of LUNA and UST is seriously inverted

4 LUNA-UST’s death spiral

5 UST’s price stabilization mechanism is vulnerable

6 LUNA—UST’s Ending

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In just a few days, LUNA, the star project of 2021, with a market value of nearly US$50 billion (41 billion) at its peak, fell from heaven to hell, its market value plummeted to US$100 million, and its price fell from a high of US$119 to US$0.01. Billions of dollars were wiped out in a tragedy known as the "512 Tragedy". The epicenter of this earthquake was Binance, the world's largest exchange, and the source was Do Kwon, the dangerous Korean man who created several algorithmic stablecoins (Basic Cash).

So, what is the reason for this tragedy? What is the mechanism? What is the future of LUNA?

LUNA — UST’s Dual Currency Helix

To understand the first tragedy in the cryptocurrency market in 2022, we must first understand the dual token mechanism of LUNA-UST.

UST is a stablecoin on the Terra chain. By burning $1 of the on-chain token LUNA, an equivalent amount of UST can be minted, and vice versa.

UST's arbitrage mechanism is reflexive. When the UST price is higher than the anchor value (US$1), users can burn US$1 of LUNA and mint 1 UST, thereby increasing the supply of UST and returning it to the anchor value. Conversely, when the UST price is lower than the anchor value, users can burn 1 UST and obtain US$1 of LUNA.

Most of UST is stored on Anchor. Anchor is a lending protocol on the Terra chain, which is equivalent to the official bank on the chain. By offering ultra-high APY, it attracts users to deposit huge amounts of UST, greatly increasing the supply of UST.

The amount of UST to be “digested” is huge

UST once had a market value of up to 18.6 billion, most of which was stored in Anchor to earn nearly 20% APY. The peak deposit of UST in Anchor exceeded 14 billion US dollars. In addition, UST deposits are far greater than loans. This means that the actual circulation and utilization rate of UST are not high. On average, at least 80% is locked in Anchor, like a "dammed lake".

The market capitalization of LUNA and UST is seriously inverted

Theoretically, since UST is minted through LUNA, to ensure the stability of UST, the market value of LUNA must be at least as high as the market value of UST. When the market value of UST is less than the market value of LUNA, the safety margin is higher.

However, as of May 12, 2022, UST's market capitalization is approximately US$8.7 billion, while LUNA's current market capitalization is only US$100 million. LUNA/UST is already seriously insolvent and in desperate situation.

LUNA—UST’s Death Spiral

When the market value of UST and LUNA is inverted, UST will inevitably be depegged. After depegging, UST is discounted in the secondary market, but according to Terra's on-chain mechanism, 1 UST can still be exchanged for 1 US dollar of LUNA. This will cause a large number of users to exchange and sell LUNA on the chain. During the run, the price of LUNA will be under tremendous downward pressure, and the market value of LUNA will fall faster than UST, causing UST to be depegged more seriously, and the market will be more panic, forming a vicious circle.

Furthermore, the positive feedback mechanism of LUNA-UST determines that when accidental factors cause the market's confidence in it to collapse and UST becomes unpegged, it has no internal stabilization mechanism to return to the "steady state" and must rely on LFG's expectation guidance or real money to stabilize. Therefore, it is extremely dependent on LFG's "lender of last resort" role and actual "lender of last resort" strength, and is full of uncertainty.

Since May 8, some whales have sold about $300 million of UST, causing it to de-anchor slightly. It may be that seeing that UST has not been restored to its anchor for a long time, whales with millions of dollars have fled one after another. The thin circulation of UST cannot bear the continuous selling pressure, which eventually caused a flash crash of UST and also brought down the price of LUNA, forming a death spiral.

Although Anchor raised the interest rate to 19% in an attempt to retain users, as panic spread, Anchor's depositors continued to leave. Currently, the market value of UST is about 8.7 billion US dollars, while the UST locked-up amount in Anchor is less than 3.3 billion US dollars, which means that more than 4 billion US dollars of UST are still in circulation, which will form a continuous selling pressure on the price of UST.

UST’s price stabilization mechanism is vulnerable

The liquidity of LUNA/UST is shared, and UST itself is backed by the market value of LUNA, so LUNA can be regarded as an asset on Terra, and UST is a liability. When the market value of LUNA is greater than UST, the asset value is greater than the debt value, and the system is safe. However, the issuance of UST is too fast, accumulating too much risk, and it is now in a dilemma where the debt value exceeds the asset value by about 8 billion.

There are two main issues with UST price support. First, suppose you buy LUNA for $10 and then it rises to $20. During the appreciation process, because it is a small sample pricing, there is no need to change hands completely, so the funds required are less than $10, but 20 UST can be minted. The assets in the system have increased by less than $20, but there is an additional $20 in debt. In the rising cycle of LUNA, such insufficiently minted debts will be gradually accumulated and released in a concentrated manner during the falling cycle.

Second, minting UST is equivalent to selling LUNA to the system. However, in the process of selling LUNA, since the price of LUNA has not fallen yet, UST is minted according to the LUNA market price through the oracle, so the minted debt is actually greater than the asset value. In theory, the system should have a certain safety margin. In the process of minting UST, more LUNA is consumed to hedge the price drop of LUNA after sale, and the market value of LUNA is pushed up to ensure that the asset value is always greater than the debt. The excessively fast issuance speed of UST and the price feeding mechanism have accumulated risks together, leading to the outbreak of a death spiral.

Terra may have also realized the drawbacks of its price support mechanism and introduced foreign exchange reserves. As an algorithmic stablecoin, centralized stablecoins are theoretically impossible for Terra to choose, so LFG purchased $1.5 billion of BTC as asset endorsement, essentially trying to tie UST and BTC to the same chariot and try to expand the liquidity that the system can share.

But before a new endorsement mechanism with BTC was established, UST was depegged. Now it seems that Terra's introduction of BTC was more like a risk warning. Currently, LFG has liquidated all BTC to protect the market, but compared with the market value difference between UST and LUNA, it is still a drop in the bucket.

LUNA—The End of UST

Judging from the current situation of UST, the biggest risk of stablecoin calculation is user confidence. Once users lose confidence in stablecoin calculation, panic will spread rapidly, and then continue to sell stablecoins, triggering a death spiral.

The reason why users lose confidence is that the collateral behind the stablecoin is insufficient. When the market fluctuates violently, it is very easy to trigger large-scale liquidation or redemption. The huge amount of selling will bring an unbearable blow to the coin price. UST is minted by burning LUNA. Fundamentally, LUNA is the collateral of UST. In contrast, Dai's collateral is ETH, which is one of the assets with the highest consensus in the market and has a very high collateral ratio. Even large-scale liquidations can ensure the stability of the coin price. Another well-known stablecoin Frax also has USDC with a high collateral ratio. Although USDC has been criticized for being centralized, USDC is the most transparent stablecoin on the market. When the market fluctuates violently, LUNA cannot maintain user confidence like ETH, USDC, etc., which leads to the current situation.

There is nothing wrong with Terra's own strategy. As the project expands, the unsustainable rate of return in Anchor will be gradually reduced and BTC will be introduced as asset endorsement, so as to establish a deeper correlation between UST and the crypto assets with the highest consensus, in order to enhance user confidence and prevent runs.

In the early stage of UST anchoring, although the BTC endorsement mechanism has not yet been deployed, there is still a glimmer of hope.

First of all, Terra decisively closed the minting channel, otherwise there would be a large number of secondary market players arbitrage on Terra. Rather than letting others make money that cannot be recovered, it is better for the official to personally arbitrage and bring the money back to LFG. Use limited funds to stabilize the market value of LUNA as much as possible, and let the long and short parties play freely on UST. Even if the price of UST may be very bad, its asset value has stabilized and its debt value has shrunk. As long as the two can eventually converge and ensure that a part of UST is rigidly redeemed every day, users can continue to have confidence in UST.

Secondly, significantly increase the borrowing rates of UST on Anchor and other lending protocols, increase the costs of short UST borrowers, and force them to repay as soon as possible, otherwise they will have to face high interest rates, thereby creating some buying of UST.

Unfortunately, Terra is doing the exact opposite. At present, the result of opening the recast channel is that LUNA's liquidity is constantly fleeing, the depth is getting shallower, and the slippage is getting bigger. The market value is falling rapidly with the price of the currency, and the more it falls, the less the circulating volume is. UST still has about 6 billion in stock, and it is almost impossible for LUNA to hold up.

In addition, the plummeting LUNA market value will also pose a threat to the ecology of the Terra chain. If the staked value of the node is far lower than the value of the fund pool, it may lead to a large number of node attacks, causing huge losses to the ecology. If security cannot be guaranteed, what is the meaning of the public chain?

At present, LUNA is still continuing its issuance, and the price of UST is also plummeting. There is a high probability that there will be another tombstone in the graveyard of algorithmic stablecoins.

As for what kind of algorithmic stablecoin can be successful, this is a question that will be discussed in our subsequent reports, so stay tuned.

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