Luna and UST are the native tokens of the Terra network and are interconnected with each other. While UST is a stablecoin, Luna is a utility coin that backs UST’s $1 price with its peg mechanism. The Terra foundation guarantees UST investors that they can swap 1 UST for $1 Luna, no matter the market price. In this way, the trust for the algorithmic stablecoin is created. Another critical part of the Terra ecosystem is the Anchor protocol that offers 20% fixed APY on UST deposits. It is the only use case of stablecoin, which also lead to its demise. So, before diving into why did Luna and UST crash, let’s look at a few fundamentals.
How do Luna and UST swapping work?
The swap system of Luna and UST is pretty simple. Users can swap 1 UST for $1 of Luna and vice versa. When 1 UST is swapped for $1 Luna, the new Luna needs to be minted, and UST is burned. And similarly, if $1 Luna is swapped for UST, Luna gets burned, and UST gets minted.
Now, all this might seem good to go, but there are some problems associated with this mechanism. Let’s say the demand for UST falls, which means more users swap their UST for Luna increasing its supply. This will significantly affect the price of Luna. This is what happened in the past few days.
The arbitrage opportunity and the death spiral
If 1 UST remains pegged to the dollar and is swapped for $1 Luna, it won’t be much of an issue. However, now that it’s depegged, it creates a huge arbitrage opportunity for investors. One can buy more than 1 UST for $1 and then swap it for Luna and sell it on the open market. This will create further selling pressure for Luna and also continue to pressure the peg of UST.
For example, Let’s say UST drops to $0.5, so investors can buy 20 UST for $10 and swap it for $20 worth of Luna and sell it in the open market, making an easy 100% profit. They can continue this cycle and keep making profits.
So, once the depeg happens, it has become very difficult for the Terra Foundation to get UST back to $1. It is also called a death spiral as it is a recurring cycle where less price for UST means more swapping to Luna, which will further push Luna’s price down, leading to more minting of UST and swapping.
Why did Luna and UST crash?
Luna was such a sought-after project that it held its ground even during bear markets. So, it was surprising to see that the price crashed by 99% in a matter of a few days. Let’s look at the things that happened over the past week that led to this.
1) The $193 M dump and Anchor protocol
A while back, a huge UST dump took place worth around $200M. This dump depegged UST to $0.985, but the peg recovered the following day. However, this depeg created a lot of panic and FUD in the market. Last weekend, users started to withdraw their UST from Anchor protocol to cash it out for Luna, and this created even more pressure on UST. Around $3 billion were withdrawn from the Anchor protocol during the weekend that offered 20% APY on UST.
There were also rumors that the dump was orchestrated by Do Kwon, the founder of Terra. This created even more panic, and as UST crashed, users started to swap it for Luna and dump them in the open market. It created such a huge sell pressure that in a matter of 2-3 days, Luna fell below $1. It is currently trading near 30 cents.
The arbitrage opportunity that was present in this algorithmic stablecoin was exploited by users, and this destroyed the project. I say destroyed because it’s hard to believe that users can ever get the same level of trust in Luna.
Also Read: Terra’s CEO suspected of $84M dump before UST’s depegging
2) Market conditions
Even the current market conditions are such that Luna faces even more sell pressure. Bitcoin has crashed below $30k, and altcoins continue to bleed. While I won’t say this is the primary cause for Luna’s crash, it did add to the negative sentiment that’s surrounding the project currently. Whoever dumped the $193 million UST in the market planned the timing perfectly.
3) Lack of use cases
There aren’t many use cases of the stablecoin UST. Almost 75% or $14 billion of its market cap was locked in Anchor Protocol which offered nearly 20% APY every year. It shows that most investors were here just to earn a hefty interest on their money. But many analysts say that this was not very sustainable as the funds of the project were going to dry up sooner or later. Plus, the investors were here only for the returns. Therefore, as soon as the price crashed a bit, they started cashing out. Only, if UST had more use cases and higher volume, this might not have happened. I hope these 3 points explain why did Luna and UST crash.
Terra’s Bitcoin reserves to the rescue?
$UST with $10B+ in $BTC reserves will open a new monetary era of the Bitcoin standard.
P2P electronic cash that is easier to spend and more attractive to hold #btc
— Do Kwon 🌕 (@stablekwon) March 14, 2022
A while back, Terra Foundation announced that they are going to acquire $10 billion in Bitcoin to protect the peg of UST. They were able to buy around $4 billion in Bitcoin, and these funds were used to prevent Luna from going down even further, but it didn’t help much.
The Luna Foundation loaned $750 million of Bitcoin to trading firms that are market markets with the goal of helping the market normalize. Since Bitcoin has more liquidity than Luna, it also allows users to swap their UST for $1 in BTC, which will take off the selling pressure from Luna. The foundation subsequently dumped billions of dollars in Bitcoin into the open market.
While they tried to stabilize things with their BTC reserves, it just added to the current instability in the market. Bitcoin’s price did get affected by this dump.
What’s next?
1/ Dear Terra Community:
— Do Kwon 🌕 (@stablekwon) May 11, 2022
The most important thing after the crash is how the Terra Foundation reacts. What happened was definitely not planned, and in a way, you can say that the experiment of an algorithmic stablecoin failed miserably. Do Kwon, the founder of the project, has proposed some measures they are taking in order to repeg UST to the dollar and possibly help Luna regain some ground.
He said that before the repeg happens, UST will need to absorb the selling pressure that’s being created. There will be no way around it. They are increasing the mining capacity of Luna by almost 5 times to allow the system to absorb UST much more quickly. This is definitely going to impact Luna’s price even further, but it seems there is no way around it.
Terra is also going to need a lot of funds to get over this mess. They can probably raise these funds by allocating tokens to VCs at discounted rates and have fixed unlocking periods for them, so they cannot dump them in the open market.
What happens if the UST peg restores?
It’s not going to be all sunshine even if the Terra foundation is able to get UST back to $1. A lot of investors might have been holding the token with the hope that the price will recover, and once it does, they will dump the tokens and never look back. So, when UST does reach $1, it could create another wave of sellers, which could depeg it again. Well, if Luna foundation plans what to do in such a scenario, then things could happen differently. Things look complicated for Terra right now.
The implications of such a huge crash
With the crash of Luna and UST, US lawmakers have again pushed for stablecoin regulation. Janet Yellen, Secretary of Treasury, also pointed out the case of UST and reaffirmed the need for a proper stablecoin regulation. They even said that stablecoins could pose a danger to the economic stability of the United States. Janet has requested the bipartisan to formulate a strong framework and said that she is looking forward to working with them.
This clearly explains why did Luna and UST crash, but if you still have any doubts, let us know in the comments below. I will try to clear any queries. Were you holding any Luna before this, or will you get some now just as a gamble? Let us know. Also, if you found our content informative, do like and share it with your friends.
Also Read: UST loses dollar peg while Luna foundation tries desperately to defend it.
