LUNA and UST implodes - the story of a ticking timebomb

The story of the biggest collapse in recent crypto history.

LUNA and UST implodes - the story of a ticking timebomb

Terra and its ecosystem has literally imploded with significant investor losses over the past three days.

LUNA, the native token of the Terra ecosystem, is down 99.9% in 48 hours, trading as low as US$0.003, from its highs ($116) reached just last month. That means everyone who bought LUNA at any step of the way would have seen losses.

90% losses each day, every day for the past 3 days:

  • $100 to $10
  • $10 to $1
  • $1 to $0.1

UST, the stablecoin pegged to the US Dollar native to Anchor Protocol, traded 75% off at $0.25. That has sent LUNA, the native token of the Terra protocol, into a downward spiral as LUNA is used to keep UST's peg.

But why did the collapse happen? Who's to blame?

LUNA and UST peg

The story begins with LUNA and UST (TerraUSD). LUNA is the native blockchain token of the Terra ecosystem, just like other tokens like ETH (Ethereum), FTM (Fantom) and SOL (Solana).

Assuming LUNA has value, one could LUNA to create another arbitrary stablecoin worth $1 called UST, that derives its value based on LUNA. The arbitrage relationship works like this:

  • 1 UST is worth $1
  • 1 UST can be traded for $1 of LUNA with a floating quantity

If the price of UST falls below $1, e.g. $0.99, traders are incentivised to swap $0.99 UST for $1 worth of LUNA; and the reduction in UST supply would push it to $1. Similarly, if the price of UST goes above $1, the mechanism applies in reverse.

Now, this phenomenon assumes that LUNA has value. As long as LUNA has value, you could redeem 1 UST for $1 of LUNA, regardless of LUNA's price. And as long as there is demand for Anchor Protocol's UST deposits at 20% APY, then users would mint UST and burn LUNA in the process.

Unlike traditional fiat-backed stablecoins like USDC, which have their tokens backed by real assets like cash or highly rated bonds on a 1-to-1 basis which give them a guaranteed redemption value, UST does not rely on the use of such collateral to derive its value. Instead, it's an algorithmic stablecoin that uses LUNA to derive its value.

UST admittedly, has no reason to be worth $1 if the price of LUNA is $0. Hence, earlier this year, an entity called the Luna Foundation Guard (LFG) with the goal of protecting the UST peg, committed to buy and use Bitcoin (BTC) to help stablize the peg.

By using two assets (LUNA and BTC) to maintain UST's peg, it's their hope that over time, the rising demand for UST will continue to burn LUNA in circulation and send its price skyrocketing.

The fall

The collapse began when Anchor Protocol was milked for its high 20% APY during the bear market. Strategies like MIM Degenbox allowed investors to do 8x to 10x leverage on their MIM holdings into Anchor, essentially milking 140% APY.

While the growth of UST caused the price of LUNA to skyrocket, trouble was brewing behind the scenes.

Anchor's protocol reserves started dwindling as the protocol wasn't profitable as deposits ballooned. It was subsidizing depositors yield from the yield reserve, but as leverage demand fell in crypto, the Anchor rate of 20% could not keep up with the borrowing interest.

At the same time, Anchor started to see an outflow of funds when people started doubting its sustainability. You know how it works – UST outflow, new LUNA supply minted. The stability of LUNA becomes questionable and might reflexively drive more UST outflow.

Seeing this as a potential issue, the Luna Foundatin Guard announced that it has began purchasing Bitcoin to create a further backstop for TerraUSD. It acquired almost $1.7 billion in BTC to help create a financial backstop for the peg.

It also lent $750m worth of BTC to OTC trading firms to help protect the UST peg and loan $750m UST to accumulate BTC as market conditions normalize, essentially like an LP for BTC/UST.

However, critics argue that it would not support the peg at all if there was a mass exit event.

So there’s about $14 billion that needs to exit through luna in a compression or unwind. That kind of selling pressure would likely drive down the price of luna itself dramatically, essentially blocking all the exits at the exact moment the building is on fire. On a full unwind, some people are going to be left holding the bag, either in terraUSD that is depegged, or in hyperinflated luna that has no bid.

Furthermore, it would create a systemic risk for the broader crypto market, especially if the reserve was integrated in the wrong way, it could create the conditions for a future sudden flood of BTC for sale if the peg is attacked or breaks under market strain, dragging others down with it.

Implosion

Things began turning for the worse when Terra announced the 4pool on Curve Finance, and the Luna Foundation Guard starting removing $150m of liquidity on the existing UST 3pool.

An attacker accumulated $1B of UST OTC and used $350m of it to drain the 3pool, causing UST's peg to become imbalanced.

As the UST peg became imbalanced, the Luna Foundation Guard started selling BTC to defend the peg. At the same time, the attacker used the remainer to sell UST on Binance, causing depeg, more BTC selling, and a rush for the exits on Anchor, which triggered on-chain panic and congestion.

Exchanges then suspend withdrawals to Terra in response to the congestion, which triggered even more panic. More BTC gets sold to peg UST and the entire market sells off.

Eventually, the UST peg hovered at just half its original peg value, creating an exit crisis where an incredible amount of LUNA - 25 Billion LUNA to be exact - was minted to bring UST back to peg through the mint-redeem mechanism. The influx of new LUNA supply to market saw its price crater to infinity, just like how Iron Finance ended - at $0.

Impact on these events

It is no doubt that this event will have a material impact in crypto, on protocols, on governmental regulations, on consumer protection, on fundraising, on risks and more.

Hundreds of protocols like Alice Finance and Lighthouse DeFi that have built on top of Anchor, or are reliant on Anchor's yield reserves to serve a CeDeFi or neobank front-end, are going to be completely dead if Terra and Anchor goes to 0.

That includes billions of dollars of capital raised from investors backing these companies who are now faced with an existential crisis: who's going to use them now?

We will also expect governments to increasingly take note about the risks surrounding stablecoins and regulate them.

For crypto in general, it was a sad day. But on hindsight, when writing this piece, it's better for the eventual implosion to take place sooner than later, when more capital from more people who could have been suckered in by the 20% yields would be at stake.