Home Latest News What lessons can we learn from Terra's LUNA/UST meltdown? – Forkast News

What lessons can we learn from Terra's LUNA/UST meltdown? – Forkast News

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The recent sell-off of the crypto market was highlighted by Terra’s LUNA/UST failure, which left investors in shambles, erased tens of billions of dollars of value in a matter of days, and most likely will induce a strict stablecoin regulatory policy response in the near future. 
TerraUSD, or UST, was designed to be an algorithmic stablecoin — a specific digital asset pegged to the value of one U.S. dollar. To maintain their value, algorithmic stablecoins are backed by a set of smart contracts on the blockchain, also referred to as a “protocol” that requires collateral in the form of other digital assets to be put into the system in order to issue algo-stablecoins. 
In contrast to reserve-backed stablecoins — which rely on a third-party organization to manage monetary supply and maintain adequate reserves, usually in the form of U.S. Treasury bonds, cash equivalents or other traditional assets — algorithmic stablecoins do not rely on a third party but rather on programmable software to control the supply and maintain adequate collateral.
The particularity of UST, which made it very susceptible to a bank run was that UST liabilities were backed predominantly by LUNA, a sister cryptocurrency native to the same underlying network — the Terra blockchain. Every time anyone wanted to create an emission of UST, a certain amount of LUNA needed to be taken out of circulation (burned). And vice versa, every time anyone burned UST, they created (minted) LUNA tokens.
Terra’s algorithmic stablecoin and its reserve currency LUNA worked in an intentionally structured and symbiotic manner. Did it amount to a Ponzi scheme? Consider the built-in incentives.  
From as early as March 2021, the Anchor protocol — a Terra blockchain-native decentralized protocol — was offering between 18 and 23% interest rate on UST deposits, and naturally it started attracting a lot of depositors. The deal seemed almost too good to be true: All anyone needed to do is to get a hold of UST and deposit it to Anchor protocol for a 20% or so yield on the dollar. 
As the market demand for UST grew, the circulation of the stablecoin was increasing and for that, as explained before, the burning of LUNA tokens was required. It created a multi-month upward price pressure on LUNA — its price rose US$6.50 to reach a peak at US$116 in just over 13 months, an increase of 16 times. But with the increase of stakers (depositors) on Anchor protocol, the interest liabilities of the Terra blockchain skyrocketed in absolute value.
Luna Foundation Guard, a Singapore-based non-profit created to facilitate the Terra ecosystem, had to repeatedly inject capital into the Anchor protocol in order for it to be able to cover liabilities and pay out yield to depositors.
It was not a stable system in the first place, but as long as the adoption rate of UST was coupled with the growing price of LUNA, theoretically there was enough collateral, even if consisting of a single, volatile and ill-built underlying asset. 
However, when the price of LUNA began going down sharply, the real chaos began. The whole dynamic that ensued can be simplified as follows: 
When enough people are looped into this cycle, the moment comes when UST liabilities exceed its assets and a “bank run” starts. 
At this point, the market speculators play their role, too. Seeing the trembling system, they add more fuel to the fire by starting to bet against Terra ecosystem — shorting both UST and LUNA. Somewhere at this point UST starts significantly de-pegging from the value of 1 USD.
And here comes the infamous death spiral. Arbitragers begin to exploit the intertwined UST mint/burn mechanism. The relationship between the two digital assets is programmed in such a way that 1 UST can always be redeemed for US$1 worth of LUNA, irrespective of the current price of LUNA. 
So, whenever the UST is below US$1, it is economically feasible to redeem it for US$1 in LUNA and instantly sell LUNA to complete the arbitrage. Not surprisingly, that’s exactly what happened. It drained all the collateral from the system, demolished LUNA’s price and drained the majority of deposits from the Anchor protocol. The number of UST deposits went from roughly 14 billion on May 6 to 1 billion on May 19, a 93% drop in less than two weeks. It truly was a storm of biblical proportions.
Moreover, the supply of LUNA is elastic — meaning that when the price decreases, more LUNA is issued into circulation to help maintain the asset/liability balance of UST. The price drop, however, was so severe and rapid that the elasticity was a bug and not just a feature in this particular case and completely destroyed the value and recovery capability of the underlying LUNA. 
Following the UST de-peg, LUNA’s circulating supply went from 345 million to 6.5 trillion (yeah trillion) coins, essentially making it worthless. LUNA, now rebranded as Terra Classic, or LUNC, now has a price of well under US$0.0001, according to CoinMarketCap.  
Should the world have seen the LUNA/UST crisis coming? Without a question, yes. The transparent nature of the blockchain and algorithmic stablecoins, too, equips anyone curious enough with all the tools to see and understand the circulating supply model, the mint/burn cycle and collateralization mechanisms. Even with Terra, there were plenty of whistleblowers publicly campaigning for the imminent doom that approaches, but human psychology triumphed all.
Even if you were skeptical in the beginning but continued to earn a 20% yield on your assets, after a while, probably unconsciously you started to downplay the red flags and focused on the positives. At least until s*** hit the fan.
The tragic case of Terra, which could be the single biggest wealth destruction event in the crypto market, does not indicate that there is “no such thing as low-risk in crypto” but rather showcases that the market is still in its developing stage, and what we’ve witnessed may be categorized as the crypto market’s adaptation to changing environment.
TerraUSD is a particular and poorly designed stablecoin, and that’s the main reason why this experiment ended up poorly. Since then, other stablecoins and their respective collateralization mechanisms have been under market pressure too. On May 12, even Tether (USDT) — the largest centralized stablecoin, experienced a 6% de-pegging event that lasted about four hours. 
Some stablecoins got completely #rekt, some lost their peg for a period of time, and some came out unfazed, such as USDC or DAI. The lesson here is that fundamentally sound systems prevailed and acted as safe-haven assets during the overall market sell-off. It will not go unnoticed by market participants, and confidence in them will only grow.
Every upcoming contender will need to earn its place among the stablecoin elite. They will get tested, as they should, and the fittest, most eloquently designed will survive, which in the end will make the whole ecosystem more efficient, secure and resilient.
Gytis Trilikauskis is the Vilnius, Lithuania-based managing director at MEV Capital, a decentralized finance (DeFi) investment fund. He formerly worked in market research.
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