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Why & How Terra LUNA Collapsed – The Early UST Depegging Vulnerabilities in Terra Ecosystem

The biggest debate that has shaken the entire world is whether Luna and UST are going to recover or not. The people are so bent on it that they have betted millions of dollars into LUNA and UST. We have seen recently LUNA lose its peg completely and literally turned to a worthless cryptocurrency. There is a recovery strategy underway, yet as a whole it’s almost doomed as of for now. 

The critics raised the same questions back in 2021 when LUNA crashed and the same was suspected during January this year. So what led LUNA and UST to crash almost instantly? You can read about the reasons that led to the demise of LUNA. 

How is LUNA connected to Ethereum, Binance and Others? If LUNA is not rescued it causes damage to all other major blockchains. Ethereum, Solana and Binance etc. use LUNA bridge to move assets. So ultimately it becomes a challenge for all the major cryptocurrencies and it has affected the overall crypto market. So with the crash of LUNA and UST it has caused a domino effect on all other cryptocurrencies. 

So basically how LUNA works, is it just another PONZI scheme? Well, there’s already been a lot of debate done on this. We will break down how it has affected the global crypto market crash and what should have been done to save LUNA. 

What is Terrra LUNA?

Terra was founded as the overarching project that aimed at solvig a major crypto issue with the goal to introduce decentralized algorithmic stablecoins. Since its inception, a lot of debate has been carried out whether or not Terra can stay what it claims to achieve? We have broke down the usability of Terra into three major parts which pretty much explains Terra algorithmic role for the cryptocurrencies. 

LUNA, UST and Anchor – The Core of Terra Network 

These three are connected to one another for the sole purpose of making Terra work. All three Terra, UST and Anchor act in collaboration to stabilize the network. More importantly UST and LUNA if we are just talking about its network. UST is a stablecoin that aims to maintain at the price of 1USD peg. In a way that’s its core functionality. What makes the matter worse is its mechanism as there’s no collateral behind it to make its system work. It solely depends on its own. On the contrary other stablecoins like DAI or USDT are backed by some sort of collateral to stabilize them even if it’s USD itself or a stable crypto coin. 

Whereas, UST, in order to maintain its peg solely relies on arbitrage and market incentives only. It works in collaboration with LUNA which is Terra Ecosystem’s governance token. LUNA and UST work together to keep UST close to 1 dollar. 

UST/LUNA stability Mechansim

They have this Swap feature on its chain where they exchange LUNA for UST or UST for LUNA to keep it stabilised. It allows users to burn 1USD worth of LUNA and get 1UST in return minted for them by the network. The process can also be reversed by burning 1USD worth of UST and the protocol provides 1USD worth of LUNA. This is done on-chain so the users can get this deal regardless of the price of UST or LUNA’s market price such as other exchanges. 

It becomes very important to understand from right here. If a trader wants UST, there are two options, either to buy it from other exchanges or burn 1USD worth of LUNA to get UST, as per LUNA’s burning mechanism. 

Obviously, the users would choose what’s more profitable for them because sometimes UST is over $1 or under $1. The ordinary users always get puzzled, why do they have to do it in the first place? Well it comes for the UST demand fluctuating. Suppose someone wants to use dApps for Terra Ecosystem, he will need UST to do that. To get UST the Tether will be traded, for example. This will create the buying pressure in the crypto market and the UST will go up which can go even more than 1USD. If the user already has a lot of USTs and he wants to trade it for other stablecoins for any reason. That will create a selling pressure and push the UST to lose its value or simply go down less than a 1USD. 

In both scenarios Terra network relies on the arbitrageurs to bring the price of UST equal to USD. So, this is how the Terra-UST ecosystem works. 

There are few scenarios that will make this more understandable than what really happened to Terra and it crashed to zero. There are obvious reasons for that and the mechanism in itself has the loopholes. 

If UST is Over 1USD

Suppose UST is trading at $1.10 and the LUNA is $100. The arbitrager will go to their on-chain swap and burn it for 100 UST. Then he goes off the chain and swaps the $100 UST for some other stablecoin. Since, in this scenario, UST is $1.10 and the arbitrager is trading it for $100. It will generate straight $10 UST in profit for him. Now, if the number of arbitragers in hundreds of thousands and they keep doing it over and over again to earn more profits. 

This selling pressure will drive down the UST price back to $1. That’s how the Terra network works. Many have made profits over it this way. There’s a catch to it. This process is aimed at increasing the supply of UST and decreasing the supply of LUNA as the arbitragers are burning LUNA and they are getting UST minted for the burned amount. 

If UST is Under $1

On the other hand, suppose the price of 1UST is under `USD around $0.90 on the exchanges and the arbitrager buys $100 worth of UST. Then he buys UST at $0.90 of that amount and burns it for minting LUNA and then selling it on the exchanges to make a profit of $10 straight away. 

The process will drive back the price of UST back to $1 from $0.90 because the arbitragers are burning UST to mint LUNA and its price automatically stabilises. This mechanism also decreases the supply of UST and increases the supply of LUNA. 

Fluctuating Algorithmic Stablecoin 

This is where the major seeds of fiasco are sown. As the mechanism is aiming at dynamically controlling the supply and demand of LUNA and UST. The key role is expected from the arbitragers and the mechanism is designed to absorb the price change pressure. 

We all know, algorithm based stablecoins have always been very fragile. Most of them had already lost their pegs even before the bloodbath of LUNA. Some of the popular similar examples are Empty Set Dollar, Iron Finance, Ampleforth and Basis Cash etc. These all have lost their pegs permanently and all were Algorithmic Stablecoins. 

If we look at them, they seem to be regular crypto coins, actually they all are stablecoins pegged against USD. Now they are absolutely worthless because their existence dependent on their price stability. They failed miserably. The most infamous algorithmic stablecoin failure was Iron Finance. Iron Finance was the same as Terra is today, in which Iron was like UST and Titan was LUNA. 

For quite sometime the Iron Finance was doing amazing progress and the price of Titan was rocketing high until one day, its stability algorithm failed to stabilize and the protocol was minting more and more Titan coins that led to hyperinflation. As a result, eventually the network was unable to regain its peg and the price of Titan dropped to $0 in the matter of hours which is there until today. Many investors including Mark Cuban stressed upon the need for doing something for stablecoins. 

Terra Vs Other Algorithmic Stablecoins 

Many experts believed the Terra ecosystem would not face the same fate as similar coins before that. However, this current bloodbath has proven them wrong ultimately and a couple of times before that. See about the second scenario we mentioned where UST is $0.90 cents and the arbitgragers burn it to mint LUNA. Then sell LUNA and earn profit. They do it over and gain and eventually it complexes the situation as UST fails to get back to $1. This scenario causes great pressure on LUNA and its order books. 

So the order books just hold this record for the order to buy. If the order book shows ‘Buy Thin’ that means there are not many orders in the book for buying. Since there is no demand for LUNA to buy yet it is minted and getting dumped, this will drive the immense pressure on the price of the coin to crash hard. 

This is the same death spiral which drove the price of LUNA for bloodbath. As LUNA’s price fell, this shook people’s confidence in its peg that its stability is highly unreliable. Here it works:

LUNA Price drops= drive people to lose confidence in its peg UST = They start burning UST to mint LUNA = The supply of the coins increases while apparently there’s not much demand or buy orders for it and it’s getting dumped. As we know for the amount of burned coin in USD we get the minted amount of the other coin like LUNA for UST of $1.

So as the price decreases you get more LUNA for the same price for each burned coin. This leads to enormous supply of LUNA dump on the off chain exchanges. This process keeps repeating and the price unimaginably drops to zero. 

Stability of LUNA Network 

The stability of LUNA entirely depends on its stable price. If LUNA drops, the whole system crashes no matter whatever it has done in the past. It still gets to the point of uselessness as its Market Cap becomes less than the market cap of UST. But why is that a big deal?

It’s a big deal because its system promises the users to get 1$ of LUNA minted for the $1 UST burned. But if the marketcap of LUNA is smaller than UST’s then burned amount of UST would not recover the minted amount of LUNA for the same value. 

So this is what happened recently in the case of LUNA, seeing its market cap getting lower and lower, the people lost confidence in LUNA and withdrew their funds, even major DEXs delisted LUNA. 

Liquidity 

One more important thing is how much liquidity is available on-chain and off-chain versus the swap it features. Technically, we need less liquidity on the on-chain than the off-chain. This is primary requirement. This also means more LUNA liquidity on exchanges like Binance and Uniswap than LUNA’s own chain because if the outer Order Books are thin then the price of LUNA will get badly affected and affecting its price to go down. 

There are many reasons to ponder over. The important one is why was UST under $1 for a longer time?

Well, there are tons of reasons for that. Some of which are mentioned below:

  • The users deeply felt uncertain about the stability of UST during market crash and price fluctuation in the last few months 
  • The user wanted to try other defi protocols than UST and they did not accept UST there
  • The entire LUNA ecosystem stopped working as people did not feel need for minting UST anymore as they already had enough supply of it already stored

All these reasons led to selling pressure of UST and that ultimately brought down its price. 

This makes us think why LUNA and UST tried to have more ways for creating demand instead of just relying on arbitrage.

Imagine if there were more ways of using UST things might have been different for LUNA today, the system would have stood strong to absorb the shock. 

Anchor Protocol 

We have seen that everyone has talked about Terra’s fall from grace but no one has talked about Anchor’s role in it. Anchor Protocol is another  key contributor to the whole Terra ecosystem which is used as the key lending/borrowing protocol for it. It offers a 20% yield on your UST which is one of the highest in entire crypto space. It generates a lot of profit for UST and that UST in Anchor reaping all the profits. 

There are two sides to this, because we also have borrowers who borrow on collateral on bonds and LUNA to borrow UST. The borrowers have to pay interest for that. But they are getting paid to borrow because Anchor Protocol pays them to borrow. 

This is really something out of the box for any financial system as we don’t see anywhere getting paid for borrowing. This makes the whole Anchor organisation very scamy in its own part, realizing that they are minting tokens to pay for other cryptocurrency borrowing. 

There’s one more problem that we should notice here. 

The borrowers get paid 20% regardless of whatever is happening on the borrowers’ end. So if the protocol is supposed to sustain its own integrity then the balance has to be on both sides. 

Here is how it works mathematically:

So the cost of Anchor = UST deposited by the lenders  X the 20% yield they get paid. It is called the cost of Anchor because that’s the amount Anchor has to pay out to the lenders. 

Anchor Revenue = Loans taken out X Interest Rate + the Total Collateral Staking Yield 

Revenue of Anchor – It generates revenue from two sources

(i) the interest borrowers paying 

(ii) Staking revenue generated by bonded Luna and bonded Ether that was deposited as the collateral 

So if the revenue is greater than cost, it means Anchor is generating profit which is then moved to the Yield Reserve. 

On the flipside, if revenue is less than cost then they have to dip into the Yield Reserve to pay 20% yield to the lenders. 

Now, that’s the problem, there are so many more lenders than borrowers. As a result the yield reserve has been getting drained very fast. 

The problem arises for Anchor when they have to top it up to maintain their 20% yield offer. According to the Anchor team, the high rate was promised and used as the growth tactic. 

What baffled everyone was ‘What happens when that stops?’ That’s what happened recently which we will discuss below. 

Cascading Liquidation

Anchor’s Cascading Liquidation Model – The other important thing about this whole Anchor scenario was ‘cascading liquidations’ that seemed caused by Anchor. As people used Anchor to borrow and deposit LUNA to get UST and this process is repeated over and again in order to leverage more and more. There was no issue when the price of LUNA was rising up. The issue arises when LUNA price drops. 

As recently the price of LUNA dropped miserably some positions were liquidated. As a result their collateral LUNA might have been bought by the third parties and sold on the exchanges for more profits. 

This drop of LUNA price worsened the situation further, causing LUNA liquidation even further resulting in its price to go down to zero. 

These examples are not just speculations. Anchor has caused UST to lose its peg twice previously if you can recall. Once when all the crypto was crashing in May, 2021 due to Elon Musk and China’s actions. The price of LUNA dropped dramatically because of cascading liquidations resulting in UST losing its peg instantly. 

The second time Anchor caused LUNA to lose its peg was early this year in January, when one of the members of Abracadabra Money Foundation was actually the infamous Quadriga Exchange co-founder. The exchange was found very shady when one of the founders was declared dead and mysteriously disappeared with 250 Million dollars of customers. 

Anchor and QuadrigaCX Link 

The Abracadabra introduced a mechanism called D-Gen Box which allowed people to use their UST to borrow another coin called Min and use that to borrow more UST.

The process was repeated over and over again until it was positioned to more than 120% APY. In a nutshell it was designed to milk as much yield as possible out of Anchor. As the news about its members was revealed people lost confidence in the MIN stablecoin. As a result both stablecoins lost their pegs. 

Although both times the UST pegs were restored. But many believe both times the Terra team had to get in and restore it. 

LUNA Vs Other Doomed Stablecoins 

LUNA has leverage over previous stablecoins that failed and were wiped out completely. 

  • It had legitimate ecosystem surrounding UST 
  • The utility of LUNA has also been very diverse including paying the Gas fees, acting as a validator 

The Terra team was continuously working in collaborating with Anchor to make the UST stand the test of time which it did not. 

On the Anchor’s part, bATOM and bSOL were also added to the fold of Anchor which make the system work for borrowers especially. The LUNA Foundation Guard also raised $1 billion to form the Bitcoin reserve for UST stablecoin. Although everything just fell apart for LUNA. 

Conclusion 

However, we know how vulnerable LUNA was even before as it lost its UST peg twice. The LUNA team used their own resources to recover it. As the current scenario is almost the same as previous times, the only difference is it’s worse than that. Do the LUNA team have resources to recover LUNA today? 

Today, Terra has completely lost its peg and the faith of the people too. It crumbled in a matter of a day to zero which is sad to see as Terra was somehow very strong. The Terra team has devised a recovery plan for a Terra fork which many suspect might not work. The new recovery plan may work or not, only time will tell. 

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