LUNA returns to 0 and 50 billion U.S. dollars is wiped out

In brief

From May 8, 2022, UST has been slightly unanchored and has been operating "underwater" for a long time, causing market panic. The giant whales continued to sell UST, and finally formed a death spiral. The lowest price of UST hit $0.21, and LUNA was wiped out.

The positive feedback mechanism of LUNA-UST determines that when accidental factors cause the market's confidence in it to collapse and UST breaks the anchor, it does not have an internal stabilization mechanism to bring it back to a "steady state", and must rely on LFG's expected guidance or real money Therefore, it is extremely dependent on LFG's "lender of last resort" role and actual "lender of last resort" strength, which is full of uncertainties.

UST is endorsed by the market value of LUNA, and the two share liquidity. However, UST's excessive issuance speed and price feeding mechanism have accumulated a huge amount of insufficient casting debt during the rising cycle of LUNA, and set off a death spiral in this downward cycle. LFG may have also realized the problem of price support and introduced BTC to strengthen liquidity, but the market did not give UST time.

From the crash of UST, it can be seen that the biggest risk of Suanwen is user confidence. Once users lose confidence and start panic selling, it is very easy to trigger a death spiral. The main reason why users lose confidence is that there is not enough stable collateral, and the collateral of UST is essentially LUNA. It is neither as high consensus as Dai's collateral ETH , nor as stable as Frax's collateral USDC. Originally , Terra still had a glimmer of life, but Do Kwon's wrong choice caused the market value ratio of UST/LUNA to expand rapidly, dragging the two into an abyss of eternal doom.

Contents

1 LUNA—UST’s Dual Currency Spiral

2 The volume of UST to be "digested" is huge

3 The market value of LUNA and UST are seriously inverted

4 LUNA—UST’s Death Spiral

5 UST's price stabilization mechanism is vulnerable

6 LUNA—The Endgame of UST

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In just a few days, LUNA, the star project in 2021 with a market value of nearly US$50 billion (41 billion) at its highest point, fell from heaven to hell. The market value plummeted to US$100 million, and the price fell from a high of US$119 to 0.01 US dollars, tens of billions of dollars were wiped out, known as the "512 tragedy" in history, but the epicenter of this earthquake was in Binance, the world's largest exchange, and the epicenter was the danger of creating several algorithmic stable coins (Basic Cash) Korean man - Do Kwon.

So, what is the reason for this tragedy? What is the mechanism? What is the future of LUNA?

LUNA—UST’s Dual Currency Spiral

To understand the first tragedy in the cryptocurrency market in 2022, we must first understand the dual token mechanism of LUNA-UST.

UST is a stable currency on the Terra chain. By burning LUNA, an on-chain token of $1, an equivalent amount of UST can be minted, and vice versa.

The arbitrage mechanism of UST is reflexive. When the price of UST is higher than the anchor value ($1), the user can burn $1 of LUNA and mint 1 UST, which will return to the anchor by increasing the supply of UST; vice versa , when the UST price is lower than the anchor, the user can burn 1 UST to get 1 USD of LUNA.

UST is mostly stored on Anchor. Anchor is a lending agreement on the Terra chain, which is equivalent to the official bank on the chain. By providing ultra-high APY, it attracts users to deposit a huge amount of UST, which greatly increases the supply of UST.

The volume of UST to be "digested" is huge

UST used to have a market value of 18.6 billion, most of which were stored in Anchor to obtain nearly 20% APY. The peak deposit of UST in Anchor exceeded 14 billion US dollars. In addition, UST's deposits are much larger than its borrowings. This means that the actual circulation and usage rate of UST is not high. On average, at least 80% of UST is locked in Anchor, like a "barrier lake".

The market value of LUNA and UST are seriously inverted

Theoretically speaking, since UST is minted through LUNA, to ensure the stability of UST, the market value of LUNA must be at least as high as that of UST. When the market value of UST is smaller than that of LUNA, the margin of safety is higher.

However, as of May 12, 2022, the market value of UST is about 8.7 billion US dollars, while the current market value of LUNA is only 100 million US dollars. LUNA/UST is already seriously insolvent and in a desperate situation.

LUNA—UST's Death Spiral

When the market value of UST and LUNA are inverted, UST will inevitably break the anchor. The unanchored UST is discounted in the secondary market, but according to Terra's on-chain mechanism, 1 UST can still be exchanged for 1 dollar of LUNA. This will cause a large number of users to exchange and sell LUNA on the chain. During the run, the price of LUNA will be under huge downward pressure, and the market value of LUNA will drop faster compared to UST, which will lead to more serious unanchoring of UST and more panic in the market, forming a vicious circle.

Furthermore, the positive feedback mechanism of LUNA-UST determines that when accidental factors cause the market’s confidence in it to collapse and UST breaks its anchor, there is no internal stabilization mechanism to bring it back to a “steady state” and it must rely on LFG’s expectations Guidance or real money is used for stability, so it is extremely dependent on LFG's role as the "lender of last resort" and the actual strength of the "lender of last resort", which is full of uncertainties.

Starting from May 8, some giant whales dumped UST of about 300 million US dollars, causing it to slightly unanchor. It may be that UST has not recovered its anchor for a long time, and the million-dollar whales have fled one after another. The thin circulation of UST cannot bear the continuous selling pressure, which eventually caused the flash crash of UST, and also brought down the price of LUNA. Form a death spiral.

Although Anchor raised the interest rate to 19% in an attempt to retain users, as the panic spread, depositors in Anchor continued to lose. At present, the market value of UST is about 8.7 billion US dollars, while the lock-up volume of UST in Anchor is less than 3.3 billion US dollars, which means that more than 4 billion US dollars of UST are still in circulation, which will form a continuous selling pressure on the price of UST.

UST's price stabilization mechanism is vulnerable

The liquidity of LUNA/UST is shared, and UST itself is also endorsed by the market value of LUNA, so LUNA can be regarded as an asset on Terra, and UST is a liability. When the market value of LUNA is greater than UST, the asset value is greater than the debt value, and the system is safe. However, UST's additional issuance is too fast and has accumulated too many risks, and it is now in a dilemma where the value of debt exceeds the value of assets by about 8 billion.

There are two main problems with UST price support. First, suppose you buy LUNA for $10, and then it rises to $20. During the appreciation process, because of the small sample pricing, you don’t need to change hands completely, so the funds needed are less than $10, but you can mint 20 UST. Assets in the system increased by less than $20, but liabilities increased by $20. During the rising cycle of LUNA, such insufficiently minted debts will be gradually accumulated and released in a concentrated manner during the falling cycle.

Second, casting UST is equivalent to selling LUNA to the system, but in the process of selling LUNA, since the price of LUNA has not yet fallen, UST is minted according to the market price of LUNA through the oracle, so the minted debt is actually greater than the asset value of. Theoretically, the system should leave a certain margin of safety. During the process of casting UST, by consuming more LUNA, hedging the falling price of LUNA after sales, and pushing up the market value of LUNA, to ensure that the asset value is always greater than the debt. The excessive speed of UST's additional issuance and the price feeding mechanism have accumulated risks, leading to the outbreak of the death spiral.

Terra may also have realized the disadvantages of its price support mechanism, and then introduced foreign exchange reserves. As an algorithmic stable currency, centralized stable currency is theoretically impossible for Terra to choose, so LFG purchased 1.5 billion US dollars of BTC as an asset endorsement. In essence, it wanted to tie UST and BTC to the same chariot. Attempts to expand the liquidity that the system can share.

But before the establishment of a new endorsement mechanism with BTC, UST was unanchored. Now it seems that Terra’s move to introduce BTC is more like a risk warning. At present, LFG has cleared all BTC to protect the market, but compared with the market value difference between UST and LUNA, it is still a drop in the bucket.

LUNA—The Endgame of UST

Judging from the current situation of UST, the biggest risk to the stability of UST is user confidence. Once users lose confidence in Suanben, panic will spread rapidly, and they will continue to sell stablecoins, triggering a death spiral.

The reason why users lose confidence is that the collateral behind the calculation is insufficient. When the market fluctuates violently, it is easy to trigger large-scale liquidation or redemption. A huge amount of selling orders will bring an unbearable blow to the currency price. UST is minted by burning LUNA. Fundamentally, LUNA is the collateral of UST. In contrast, Dai’s collateral is ETH, which is one of the assets with the highest consensus in the market, and has set a very high mortgage rate, which can ensure the stability of the currency price even if it is liquidated on a large scale. Frax, another well-known stable currency, also has USDC with a high mortgage rate. Although USDC has been criticized for centralization, USDC is the most transparent stable currency in the market. When the market fluctuates violently, LUNA cannot play a role in maintaining user confidence like ETH, USDC, etc., which has led to the current situation.

Terra's own strategy is not a problem. With the expansion of the project, the unsustainable rate of return in Anchor will be gradually reduced and BTC will be introduced as asset endorsement to establish a deeper correlation between UST and the encrypted asset with the highest consensus to enhance user confidence. Prevent runs.

In the early stage of UST anchoring, although the BTC endorsement mechanism has not yet been deployed, there is still a glimmer of life.

First of all, Terra decisively closed the casting channel, otherwise there will be a large number of secondary market players arbitrage on Terra. Instead of being made money that cannot be returned, it is better for the officials to arbitrage themselves and bring the money back to LFG. Use limited funds to stabilize the market value of LUNA as much as possible, and let the long and short sides freely play games on UST. Even though the price of UST may be bad, its asset value has stabilized and its debt value has shrunk. As long as the two can finally converge and guarantee a rigid payment of a part of UST every day, users can continue to maintain confidence in UST.

Secondly, substantially increase the borrowing rate of UST on Anchor and other lending agreements, increase the cost of short UST borrowers, and force them to repay as soon as possible, otherwise they will have to face high interest rates, thereby creating some UST buying.

Unfortunately, Terra does exactly the opposite. At present, the result of releasing the return channel is that the liquidity of LUNA continues to escape, the depth is getting shallower, and the slippage is getting bigger and bigger. The market value falls rapidly with the price of the currency, and the lower the price, the less the circulation. UST still has a stock of about 6 billion, and it is almost impossible for LUNA to support it.

In addition, the sharp drop in LUNA's market value will also pose a threat to the ecology on the Terra chain. If the pledged value of the node is far lower than the value of the fund pool, it may lead to a large number of node attacks, resulting in huge ecological losses. If security cannot be guaranteed, what is the point of a public chain?

At present, LUNA is still continuing its additional issuance, and the price of UST is also plummeting. There is a high probability that there will be another tombstone in the cemetery of algorithmic stablecoins.

As for what kind of algorithmic stable currency can be successful, it will be discussed in our follow-up report, so stay tuned.

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