Timeline

On May 8th 2022, the CISO of Polygon Network, Mudit Gupta tweeted about serial token movements that caused the $UST to lose its peg slightly down to $0.985 on Saturday.

He also mentioned the suspicious timing of a transaction that bridged $84M worth of $UST to Ethereum and dumped it right after the LFG’s $UST removal, which may have triggered the market sell-off.

While the $UST once recovered back to $1 on Sunday, it dropped all the way to $0.88 on May 9th 2022.

Such a huge decline forced the Luna Foundation Guard (LFG) Council to issue $1.5 billion in loans ($750 million $BTC & $750 million $UST) to save its stablecoin.

The depegging of $UST during the weekend, has greatly impacted the price of $Luna , which tanked to $28.03 on Monday.

The decline of $Luna sparks a domino effect, brought a large amount of liquidation on the Anchor protocol, which lets the $UST lost hold of its dollar peg, down to $0.61 on Tuesday morning.

As things got worse, LFG emptied its bag and unloaded 28K $BTC to buy up $UST.

Bad news ensues on Tuesday after the most recent report coming from the Federal Reserve Board that states their worries about stablecoin in its latest Financial Stability Report [1] and Binance announced it has suspended the Terra Network withdrawals.

The price of $UST dropped to $0.3 early this Wednesday, and $Luna was free-falling to $0.47. However, the LFG and Do Kwon have not accepted this defeat, as he endorsed a community proposal 1164 [2] to try to save the community.

Some Thoughts

The crash of $UST shows the instability and vulnerability of the algorithm stablecoin, and the incompleteness of Terra’s mechanisms.

The liquidity issue came first in the falling of $UST. On May 7th, After the LFG drew liquidity from the curve for 4pool, the $UST exit liquidity became vulnerable and can be cleared with just $350 million $UST, and that is exactly what happened next. Someone cleared the liquidity from the curve, dumped $UST in CEXs, and caused the depeg.

This would not happen if the 4pool was alive, since it requires $3 billion to clear the liquidity, which is unprofitable.

The automated stabilizing mechanism of $UST is pretty simple, here is an example: if $Luna is worth 50 dollars, you can always redeem it to receive 50 $UST, and vice versa.

So, when the price of $UST dropped below $1, arbitrageurs are willing to buy it and redeem $1 worth of $Luna.

Basically, if there are more $UST in the market, there will be less $Luna. As the adoption of $UST increases, the holder of $Luna will want to diamond-hand it, which explains why the Market cap of $Luna should be higher than the $UST. In this case, every $UST (in the market) will be backed by $Luna. On the other hand, if the market cap of $Luna drops below the $UST, trouble occurs, there will be FUD that $UST is undercollateralized.

Let’s consider an edge case here. If the price of $Luna was pretty high at some point, someone burned his $Luna and got tons of $UST. Then, suddenly, the price of $Luna just crashed, and this person now bought tons of $Luna with a penny (In $UST). Now, there is a great amount of fresh $Luna joins the market circulation and ready to be dumped. That’s basically how the price of $Luna got crashed during these days.

To further explain the reasons behind the crash of $UST, I have to introduce two other cornerstones of the Terra ecosystem. Anchor protocol and the Luna Foundation Guard.

Anchor protocol is the lending protocol on Terra, which offers APY around 20% for users who lock their $UST. Luna Foundation Guard is an organization created by Do Kwon, the founder of Terraform Labs, aims to support/protect the Terra ecosystem, and we have seen several efforts made by them this week to try to support the price of $UST.

Previously, LFG was replenishing the fund of Anchor by burning its reserve to maintain its high APY. The plan is to expand the adoption of $UST, make the system self-sustainable, and boost the price of $Luna to the moon before they run out of reserves.

In April 2022, LFG bought over $1.5B worth of $BTC as an extra insurance to the $UST. If the price of $UST falls below $1, sell the $BTC to buy $UST, thus restoring the peg. That’s exactly what LFG did on Monday.

I believe the reaction that LFG took is a blunder, especially when under a downward trend of the whole crypto market. It set $UST as a vulnerable target for market makers to attack. Predators can easily earn profit by just shorting the $UST/$BTC pair. Massive bearish sentiment causes purchasing power of $BTC fell, and less $UST could be bought. Then panic retail investors start to undersell their $UST, which makes the condition of Terra even worse.

Its automated stabilizing mechanism also shows its weakness at this point. Initially, people swap 1 $UST for $1 worth of $Luna, within its daily swap cap. After exceeding it, a worse exchange rate will be offered and dissuade investors from the panic sales. But when it comes to a bank run, it means the excess $UST will be burned much slower, which hinders the $UST to regain its peg.

Chain scalability also plays a crucial role in this event. When the price of $Luna got dumped quickly, people who borrowed $Luna from Anchor Protocol cannot reduce their exposure / increase collateral due to the network congestion, which causes more cascading liquidations.

As of the time of this research, the price of $Luna is $0.096 and $UST is $0.512, and I would say it’s already bankrupt at this point. I’m not sure if the proposal 1164 can somehow save the $UST, but $Luna is certainly dead now. If the $UST wants to re-peg, keeping $UST redemptions at $1 worth of $Luna, the exit liquidity for $Luna is the major issue. LFG still need billions in exit liquidity to save it.

The failure of $Luna also leads to some worries on other stablecoins, especially after the reports made by the Federal Reserve. As the stablecoin with market cap more than the sum of the second to fifth stablecoins, if regulation hits the $USDT unexpected, will cause catastrophic impact to the crypto.

Disclaimer: This research is for information purposes only. It does not constitute investment advice or a recommendation to buy or sell any investment and should not be used in the evaluation of the merits of making any investment decision.

🐦 @SoxPt50

📅 12 May 2022

References & Source:

[1] https://www.federalreserve.gov/publications/files/financial-stability-report-20220509.pdf

[2]https://agora.terra.money/t/proposal-help-ust-pegging-increase-estimated-minting-capacity-to-1200m/6287

https://www.coindesk.com/markets/2022/05/10/usts-bitcoin-reserve-too-late-in-coming-to-save-dollar-peg/

https://www.bloomberg.com/news/newsletters/2022-04-19/crypto-news-do-kwon-of-luna-terra-fame-has-10-billion-bitcoin-plan

https://www.reddit.com/r/terraluna/comments/umcabh/postmortem_on_what_happened_with_ust_depegging/