WHY DID LUNA AND UST CRASH?
A GIANT’S DOWNFALL
What happened?
As you probably have noticed already, the last few weeks have been very rough for crypto, as well as for stock holders and investors. Markets have been on a steep decline since the Federal Reserve decided to start raising interest rates like they have never before in history. The interest in order to borrow money from the FED jumped from 0.33% to 2.9% in about 2 years time, to put it further into perspective that´s a 765% increase. They also announced a 50 bps (basis points) or a 0.50% rate hike, something that was not done in more than 2 decades time.
So yes the markets in general were already on a fragile situation but to crypto’s bad luck, TERRA came to make things even worse. A week ago, give or take, LUNA was in the top 10 cryptocurrencies in terms of market capitalization. On May 7, LUNA was trading at $73 USD, five days later by May 12 its price dropped as low as $0.0000006. Nonetheless, it is important to point out that the price of LUNA dropped more than 99.98% in less than 24hrs, leaving investors shocked and without much time to take precautionary actions to hedge their positions. The same fate awaited TerraUSD (UST), the algorithmic stablecoin pegged to the US dollar in a 1:1 ratio lost its peg to the dollar and is currently trading around the $0.14 area, although it also dropped as low as $0.037
How did it play out?
A few weeks ago we published an article explaining exactly how TERRA’s ecosystem works and how their “stablecoin” algorithm should function, please refer to it if you wish to understand TERRA’s protocol better, you can find it on our Medium “The Crypto Sharks”.
To make it simple, to create UST, you need to burn LUNA and vice-versa. For example, a week ago you could have traded one LUNA token for 85 UST (due to the fact that LUNA was trading at $85 USD), however that one LUNA would be burned (erased from its supply) in the process. This deflationary mechanism was supposed to make sure the long-term growth for LUNA.
To entice traders to mint (create more) UST, TERRA’s developers team presented an insane 19.5% APY on staking via the Anchor Protocol. Anchor is/was a DeFi application where you loaned your UST and other crypto assets in order to gain that 20% yield on your savings instead of putting them at a traditional financial institution to make a 0.06% interest rate. Prior the depegging, over 70% of UST’s circulating supply, around $14 billion dollars, was locked within this scheme.
But the collapse started on May 7 when over $2 billion worth of UST was withdrawn from the Anchor Protocol, which was partially immediately sold. Currently there is a theory going around the crypto world that the withdrawal was used in order attack TERRA’s network, but we cannot know for sure now.
The massive sell order pushed the price of UST right all the way down to $0.91. Afterwards traders attempted to take advantage of the arbitrage incentive that TERRA’s burning/minting mechanism offers, which was to trade $0.91 worth of UST for $1 worth of LUNA, however not much people realized that only $100 million worth of UST can be burned for LUNA per day.
Later on as investors started to take notice that the stablecoin could not keep its peg, they sold their UST dropping its price even more. And that’s not it since no one wanted to keep their UST, billions of LUNA tokens were minted drastically increasing its supply without a substantial demand, causing it to go off a cliff.
The man behind TERRA’s demise
Do Kwon, Terraform Labs CEO, was being really cocky and disrespectful in the last couple of weeks by calling everyone poor on Twitter, making himself enemies by betting on LUNA’s price with recognized leverage traders, to even publicly threaten to fire his own developers. After LUNA and UST crashed, he said he was “heartbroken” to hear many of its believers and investors took their own lives after losing everything.
Certainly this has been one of the biggest “black swan” events in the entire crypto history if not the biggest. I firmly believe that many positive as negative things will unfold out from this historical event, like governments targeting more stablecoins and further regulation of the space.
