Made & regulated in Germany 

Gomoon’s Guide to the UST/LUNA Collapse



The spectacular collapse of the Terra USD stablecoin (ticker: UST) and the associated LUNA token has become one of the biggest incidents in cryptocurrency history and could mark something of a watershed in terms of regulation. Both tokens went from being worth tens of billions of dollars to being worth zero in little over a week, leaving many speculators terribly out of pocket.


The scale of the collapse is simply breathtaking. On May 5th, the market cap of the LUNA token was $30 billion but within a week this had been decimated to $210 million. If that still seems a little intangible, let’s consider the token price - on May 5th each LUNA token was trading for $87, and a week later it had collapsed to a barely conceivable $0.0002. Similarly, the UST token, which as a stablecoin was supposed to be pegged to $1 USD, collapsed down to $0.33 in the same timeframe.


But how did the UST/LUNA debacle come about, and what can we learn from it? Let’s find out.


Terra’s Grand Plan


Terra began life in late 2018 as a smart contract platform on which developers could build decentralised applications. The project’s creator, Do Kwon, also envisioned a dollar stablecoin that, unlike other stablecoins, was not backed by actual dollars. Instead, the UST token would rely on the project’s LUNA token (the native token of the blockchain), plus other digital assets in its reserves, to maintain UST’s one dollar valuation, with the whole thing governed by an algorithm.


The intention behind UST was for it to retain its peg through market forces, with the algorithm shifting incentives for holders in order to correct any deviations from the peg. This was based around the LUNA token - UST was created by LUNA holders swapping their LUNA for UST on a dollar value basis, with the LUNA token being destroyed once the transaction was complete. The idea was that demand for UST would grow over time, leading to the price rising above the peg, in which case UST holders were incentivised to sell for a small profit. This selling pressure would bring the peg back to one dollar again.


However, if the desire for UST dropped, or too much UST was minted in a short period, this could lead to the price losing its peg. If this were to happen, UST holders were incentivised to swap their UST tokens for LUNA tokens, reducing the supply of UST until the reduction in supply caused the price to rebound back up again, earning swappers a profit. UST holders were incentivised to act quickly before the peg was resorted, meaning that, theoretically, any drop in 1-1 peg would be quickly alleviated.


Terra also decided to back its UST coin with a mass of reserves in order to shore up more serious collapses, with the idea that it would sell some of these reserves for UST in order to catapult the price back up again. This resulted in them having a $3 billion war chest, should the need arise.



How the Crash Happened


So how did the UST/LUNA crash start? As yet, the culprit has not yet been identified, which, of course, has led to a number of conspiracy theories on the subject. This includes the suggestion that financial giants intentionally attacked the UST coin and by extension the LUNA token, in order to profit from a ‘short’ position (i.e. they bet that the price of LUNA would go down, and made sure it did). This has been denied by both the institutions concerned and the exchanges that allegedly lent them the funds to do it.


The fact is there is no evidence at all to back up any of the theories as to why the UST coin lost its peg in the first place. All we do know is that it was caught up in an overall cryptocurrency market slide, with the two coins taking what would have been a small correction to new levels.


Once UST began to lose its peg on May 9th, it didn’t take long for the rebalancing algorithm to become ineffective and for a ‘death spiral’ to begin. This death spiral, which has killed off other algorithmic stablecoins in the past, happens when holders are liquidating their positions faster than the algorithm can rebalance.


When UST first lost its peg and dropped to $0.70 on May 10, holders rushed to swap their UST for LUNA and sell it, fearing worse was to come. This was directly opposed to the expected activity of users, but the algorithm hadn’t taken into account a sudden loss of confidence in the protocol as a whole - a loss of confidence means no buyers. This led to the supply of LUNA massively increasing, with the price dropping as a result. With LUNA dropping faster than UST, more LUNA had to be minted to keep up with seller demand, all of which was all sold, further pushing the price down.


This death spiral continued until it was obvious that the algorithm was broken, at which point Terra deployed its reserves. As was revealed on May 16th, Terra sold off all but $243 million of its reserves (92%) in order to try and prop up the price of UST. However, this was still not enough to rescue it, and the two coins slipped further and further into oblivion. There are discussions over rescuing the project, but, in its current guise, the Terra USD experiment is dead.


Lessons Learnt


UST was not the first algorithmic stablecoin to fail. In fact, every attempt at a stablecoin backed by an incentivised algorithm rather than ready money has ended in failure. This will not stop others deciding that they have found the magic formula and trying another way in the future, but until these algorithms have been stress tested they represent nothing but a huge gamble.


People were also attracted to UST and LUNA because of the 30% interest offered to UST holders by a third party protocol, Anchor. This means lots of people had UST locked up that they couldn’t sell, all because of the high interest. These people should have recognised that Terra USD was an untested experiment which followed the same principles as other failed algorithmic stablecoins. Unfortunately, greed got the better of many, including those who made millions of dollars by holding LUNA past $100 but chose not to sell in search of further riches.


Instead of showing us the way to a new type of currency, Terra USD instead goes down as another example of how trying to defy financial gravity simply doesn’t work, and how greed can make us leave our risk assessments at the door.

36 views