LUNA x UST Fiasco - Riches to Rags

This week, the cryptocurrency market is experiencing a historic meltdown. At the time of writing, the price of Bitcoin is $26,775, and the cost of Ether is $1,811. However, Terra LUNA looks to be the worst performer among all cryptos, having dropped almost 90% on May 11th.

?To Understand why Terra LUNA collapsed this week requires understanding what Terra, Terra LUNA, Terra UST, and Anchor Protocol are.

What is TERRA

Terra is a blockchain similar to Ethereum. It is a protocol with its own blockchain that does not rely on other blockchains like Ethereum or Solarium. This implies that Terra's blockchain, wallets, and infrastructure operate independently of other projects. Terra is a project with a specific goal: to build a blockchain infrastructure for application deployment DeFi, which uses native stablecoins as well as the LUNA token.

Unlike Ethereum, which has only 1 token Ether, Terra has 2 tokens on its blockchain - Terra LUNA and Terra UST. LUNA is the native token of the blockchain, while UST is the stable coin built on Terra, 1 UST = 1 USD just like USDT. Besides LUNA and UST the main highlight of the Terra blockchain is Anchor Protocol. Anchor Protocol provides consumers who deposit their UST on the platform with market-leading annual rates of up to 20%.

?LUNA - UST Connection

Terra (LUNA) and TerraUSD (UST) were established by Terraform Labs, which was launched in 2018 and is headquartered in Seoul, South Korea. Do Kwon is the CEO of Terra Labs.

Do Kwon, CEO of Terraform Labs, explained how UST and LUNA work-

?The notion is that at any moment, a person may burn a dollar's worth of LUNA to mint one Terra UST, and vice versa, one Terra UST can always be redeemed for a dollar's worth of LUNA. So, as long as the LUNA token has any market value, you may always try to trade against the system to mint and redeem stablecoins.

?Now, the question arises, what happens if a de-pegging event arises? A de-pegging event occurs when a stablecoin loses its capacity to retain its value against the currency to which it is pegged. For eg, If Terra UST is trading at $0.90, a trader may simply purchase it on the open market and then trade it against the protocol for a dollar's worth of LUNA, netting a 10% trading profit. If Terra UST is ever selling at $1.10, you may buy a dollar's worth of LUNA on the open market, mint Terra UST, and then sell for a 10% profit on the opposite side. This is supposed to maintain the peg.

?The Collapse

Terra has broken its peg. After lingering at $1 for over a year, the value of UST dropped, first to 70 cents, then to 35 cents on Wednesday afternoon. The intricate computational algorithm that was designed to keep the currency trading at a fixed price failed as speculators raced to sell their positions quicker than the automated stabilizers could kick in.

?A floating token known as LUNA makes up the other half of the Terra stablecoin. When the UST value falls too low, LUNA holders are meant to swap their coins in, keeping the price stable automatically. However, LUNA's value has plummeted, from $86 last week to only 10 cents today.

?Terra was seen as a shining star in the "decentralized finance" sector. However, critics compared the algorithm to a Ponzi scheme rather than a true reserve-backed currency. As a result, thousands of investors who believed they had stumbled onto a get-rich-quick scheme have lost nearly all their money.

?The Speculation

The reason for the crash is still being investigated. However, Anchor withdrawals are widely believed to have caused UST’s decline. A large UST dump of roughly $200 million happened not long ago. UST was de-pegged to $0.985 due to this dump, but the peg rebounded the next day. However, the depreciation sparked widespread panic and fear in the market. Users began withdrawing their UST from Anchor protocol last weekend in order to cash it out for LUNA, putting more pressure on the UST. Almost $3 billion was taken out of the Anchor protocol during the weekend, which provided a 20% return on UST.

?There are also claims that Do Kwon, Terra's founder, engineered the dump. As UST began to plummet, customers began to trade it for LUNA and sell them on the open market, causing even more panic. It caused so much selling pressure that LUNA plummeted below $1 in only 2 days.

?However, Defenders of LUNA have termed this crash as an assault, although it's unclear if it was anything more than a massive cash withdrawal they couldn't cover. Binance briefly suspended trade of the stablecoin as it was in free decline. Kwon's LFG put in $1.5 billion, half of it in Bitcoin and half in UST, to try to save Terra, which hasn't worked till now.

?Some speculate that it was a personal assault since Do Kwon has a reputation for arrogance on Twitter.

?Although, there’s another theory floating around, fueled by Cardano's founder Charles Hoskinson. In a later deleted tweet, he said - “A large institution borrowed 100,000 Bitcoin from Gemini exchange. They then exchanged a large amount of that BTC for UST over the counter (OTC) with Do Kwon at a discount. He agreed, lowering the UST liquidity.

That institution then allegedly dumped large amounts of both BTC and UST on the market causing a liquidation cascade of leveraged longs, slippage, and panic selling by investors, many of which sold their LUNA holdings and unstacked their UST to sell it.”

?However, Gemini has rejected claims that it loaned 100,000 BTC ($3 billion) to any institution.

?Conclusion

Users took advantage of the arbitrage opportunity in this algorithmic stablecoin, resulting in the project's collapse. It's difficult to believe that LUNA will ever gain the same amount of user confidence.

Even if the Terra Foundation is successful in restoring UST to $1. Many investors might've been holding the token in the hopes of a price recovery, and if that happens, they will dump the tokens and never think back about LUNA. When UST reaches $1, it may trigger another wave of sellers, de-pegging it once again.

This crash has made one thing certainly clear - These coins labeled as ‘stablecoin’ are nothing but a mere experiment. Before investing your money in such experiments, you should be aware of the risks involved. When it comes to such experiments, the risk is shared not only by the founders but also by every user that participates in the project.