A week ago, a crypto project from Top-10, Terra’s LUNA, went to zero as its stablecoin UST gradually lost the $1 peg. How did a project that so many users, experts and investors were confident in, collapsed on itself? In this article, find the LUNA crash explained from the very beginning to the present and even into the future.
What are Terra, LUNA and UST?
Terra is a Tendermint-based blockchain platform that was mainly used for issuing seigniorage-based algorithmic stablecoins. Aside from the dollar-pegged Terra USD (UST), there also were euro-, and International Monetary Fund’s basket-pegged stablecoins.
In crypto, seigniorage is a mechanism that backs a stablecoin by balancing its value with the value of a native token — in Terra’s case it was LUNA. When a stablecoin gets off the peg, the algorithm burns or mints LUNA to buy out or sell for a difference in the rate.
For more information, you can check out our deep dive into Terra and LUNA, before the LUNA crash.
How does the UST peg work?
So, how was Terra’s seigniorage supposed to work and why did it collapse? Terra used a two-token system and supply expansion and contraction to balance the prices of tokens.
Let’s look at the interaction between UST peg and LUNA supply. When the market demand pushes UST above the $1 peg, its supply pool is expanded by having users burn LUNA.
The UST pool expands, diluting the price of a stablecoin. Meanwhile, some LUNA are burned in exchange for the stablecoin, its pool shrinks and the value of this token increases.
In the event that UST goes below its peg, the opposite happens: the pool of LUNA expands, allowing to buy the stablecoin out for a lower price. UST gets scarcer and more expensive until the target price is reached.
On paper and for a while, this was a working model. How did LUNA collapse, then?
Why did UST lose the peg and LUNA fall?
Obviously, there were more factors in the picture that led to the LUNA crash. One of them is Terra-native lending protocol Anchor Protocol, which promised a 20% APY on UST loans.
Anchor Protocol’s fatal flaws were a) it did not generate enough revenue to justify the handsome payouts and b) it relied on an algorithmic stablecoin. In a capitulation scenario (in which confidence falls so much, a significant majority sells), Anchor Protocol served as a leverage that exacerbated the selling pressure that brought UST and LUNA under.
On May 7, 2022, the first signs of high-volume withdrawals from Anchor Protocol and Curve Finance were seen — later rumored to be institutions like BlackRock or Citadel (both denied). By the morning of May 8, 2022, with UST 2 cents below its peg, the first signs of the UST depeg were seen but it had not looked very grim yet.
The shaky weekend had to be dealt with, and on May 9, 2022 Luna Foundation Guard (LFG) announced they will deploy $1.5 billion in equal parts BTC and UST to defend the peg. What was supposed to be good news turned out to accelerate the death spiral, as UST dipped to $0.95.
Since the algorithm was also automatically defending the peg, the LUNA minting also ramped up. Why is LUNA removed from Binance? As the week went on, LUNA collapsed from $118 to $3, as the algorithm minted billions of LUNA that people were not buying anymore.
Why did the LUNA crash affect the entire market, though? The answer lies in the Luna Foundation Guard, which was responsible for keeping the coins afloat and pledged to stash so much Bitcoin to rival Satoshi himself.
Which they were well on their way to do, since in April 2022 they started to rapidly accumulate BTC in their custody, arriving at 80 thousand coins. As the death spiral unraveled, they managed to burn through it all — which definitely increased the selling pressure on Bitcoin, affecting the entire market in turn.
The collapse of Terra also significantly reduced investor confidence and wiped $30 billion of value from the market.
What’s the future for Luna and UST?
Now the part of the community which hasn’t capitulated for good is weighing their options to find a future after the LUNA crash. Do Kwon, founder of Terraform Labs, suggested forking the blockchain for a fresh start, but some LUNAtics would like to carry on without them in the picture.
What the future holds is anyone’s guess, but we asked our CMO Alexey to weigh in on the situation:
The main problem with LUNA right now is that its popularity hinged entirely on UST. Due to a flawed design, it lost its peg and dragged LUNA down with it.
It could have been prevented with some artificial measures: stopping the transactions, reimbursing, halting the contract. Instead, [LFG] chose to do nothing and diluted LUNA’s supply beyond recovery.
One of the suggested ways to keep Terra alive was to fork the blockchain; roll it back to an instance before the collapse and split it into LUNA and LUNA Classic. The exact same solution was already tested with Ethereum and Ethereum Classic but the difference here is that there were no attacks.
Another solution, which involves Terra Station and rewards for LUNA staking and buying, on the promise that the token will recover and losses will be reimbursed is doomed to fail, exactly because it does not involve UST that made LUNA so popular in the first place.
Everyone has sobered up to see that the design is not working, and Do Kwon is trying his best to bluff his way out of the legal trouble and ruined reputation. It’s not hard to see why: he used to be behind project number seven that went to zero and everyone is now calling a scam.
I wouldn’t bet on them ever recovering but with LUNA now being dirt cheap, it wouldn’t hurt to buy just a little and wait and see. Terra’s case is huge, and will definitely lead to more scrutiny and pressure for stablecoins.
LUNA’s future is not looking very bright, and it’s a shame it led to so much loss.
The LUNA crash was a historic case for the crypto market, showing that numbers do not equal reliability. Its aftermath will most likely affect the market for the years to come.