The Destruction of Terra’s UST and LUNA.
Even as the entire crypto market tanked, the dual implosion of Terra’s UST and LUNA was the biggest story. This is what happened.
The collapse of Terra’s UST stablecoin and governance token LUNA emerged as the biggest story of the craziest week in crypto history. LUNA, formerly a top 10 coin by market cap, fell 100 percent to a fraction of a cent during the crash, and UST, which was designed to remain pegged at $1, bottomed out at 13 cents.
So, what exactly happened? Get some coffee because you’re going to need it.
Several forces were at work. The first is Terra’s and its stablecoin’s mechanism. The second was widespread panic. Many investors, who may have been completely unaware of why the stablecoin was dropping, fled at the first whiff of a debugging.
Anchor Protocol, Terra’s high-interest savings account, has been steadily lowering the rates it offers holders for depositing UST, as mentioned in a previous edition of Decrypting DeFi.
What began at 20% and was marketed as “stable” gradually began to fall following the passage of Proposal 20 in March. The interest rate would rise if Anchor’s reserves increased by 5%, according to this proposal. If these reserves fell by 5%, the interest rate would fall as well.
Furthermore, if there were more lenders than borrowers on the platform, this rate was expected to fall by 1.5 percentage points each month (which there has been historical).
With interest rates expected to fall, the primary use case for UST began to wane. On April 23, for example, Anchor held more than 72 percent of all UST in circulation. The entire point of this stablecoin was for it to be deposited in Anchor.
When it became clear that the 20% interest rate would not last, UST holders began to flee.
The anchor had approximately 14 billion UST on Friday, May 6. By Sunday, the figure had risen to 11.7 billion. Remember, UST was still pretty much pegged to the dollar at the time, so roughly $2.3 billion in the capital left the country over the weekend.
And, given that UST holders were only interested in the Terra network because of Anchor, their departures meant they had no use for that UST.
As a result, we had a mass exodus.
You have two options for leaving UST.
The first option is Terra’s (in)famous burn-and-mint mechanism.
Holders can use this mechanism to exchange one UST for one LUNA, destroying the UST in the process. Whenever 1 UST falls below $1, this creates an arbitrage opportunity, as speculators can buy the discounted UST and trade it in for $1 in LUNA, making a small profit. The inverse is also true: if UST trades for more than $1, you can swap (and burn) $1 of LUNA for that UST.
The second option is to use the stablecoin exchange Curve Finance.
When a stablecoin experiences a minor price change, savvy arbitragers will typically head over to DeFi’s deepest liquidity pools on Curve and trade the discounted stablecoin to whichever alternative has maintained its peg.
For example, if DAI is trading at $0.99, investors will purchase the discounted DAI and sell it for USDC (in this case, $1) to profit. Normally, this buy pressure drives the price of DAI back up to $1. This is also true for UST.
That’s the general plan. Let’s take a look at why this went so wrong for UST.
First, there’s the burn-and-mint exit. The chart below illustrates the sudden surge in interest via this exit. The UST supply cratered as it burned, while the LUNA supply mooned.
This was also not a painless exit, as users encountered a number of technical issues.
Remember that Terra is still a blockchain network with gas fees for activity. Along with higher gas prices, the network is also constrained in terms of how much UST or LUNA can be burned or minted at once.
Because things were slow and congested, exchanges began to pause withdrawals.
— Binance (@binance) May 10, 2022
This burn-and-mint mechanism may also have an effect on the LUNA price.
Swapping and burning UST for LUNA results in more LUNA being minted, diluting the supply and lowering the price of this token. Furthermore, as the price of LUNA falls, whenever you exchange 1 UST for $1 worth of LUNA, you will need more and more LUNA to reach that $1 mark (which means minting even more LUNA).
At some point, the price of LUNA may fall so low that there isn’t enough liquidity to provide an escape route for all of the UST coming in. But more on that in a minute.
Here’s how the second exit option, Curve Finance, looked.
Over the weekend, UST fell by less than $0.02 as Anchor employees swooped in and began trading UST for any other stablecoin, such as Tether’s USDT or Circle’s USDC.
Eventually, the pool that allowed these trades (called the “UST + 3Crv” pool, which also included all of the major stablecoins) became unbalanced, meaning there was far more UST in the pool than the other stablecoins.
Let’s take a moment to explain what happens when you sell UST for USDC on Curve.
If you sell UST on Curve for USDC, you will add more UST to this pool while removing USDC. The pool will eventually contain more UST than USDC. To correct course, the pool begins to offer that UST at a discount in the hopes of convincing arbitragers to make the opposite trade (and rebalance the pool).
This is why we started seeing a slight depegging over the weekend—Curve was doing what it has been doing since its inception.
The issue in this case was that the opposite trade, which would rebalance the pool, was not taking place. Despite the relatively lucrative arbitrage trade, it appeared that no one wanted to own UST. As for why, keep in mind that Terra’s top app, Anchor, had begun to falter.
At the time of writing, at least one investor had sold over 85 million UST tokens in exchange for 84.5 million USDC tokens in this pool. This, of course, increased pressure on UST’s dollar peg as Curve continued to create the discount in the hopes of incentivizing arbitrage traders to rebalance the pool. And you go down.
— Curve Whale Watching (@CurveSwaps) May 7, 2022
Everyone on the internet was soon watching UST lose its peg and the price of LUNA plummet.
On Sunday, a $0.02 depreciation became a whopping $0.32 by Tuesday. Simultaneously, the $64 LUNA token fell below $30.
It was also around this time that UST’s market capitalization began to overtake LUNA’s, implying that the latter would no longer be able to absorb the former, resulting in a death spiral.
The Luna Foundation Guard (LFG) naturally intervened.
It poured a tonne of UST (approximately $216 million from Jump Capital, whose president also serves on the LFG Council) into the Curve pool to assist the stablecoin in finding its peg. It then reportedly began deploying its Bitcoin holdings to a “professional market maker,” who was essentially told to spend BTC when UST fell below the peg (and vice versa if it ever trades above the peg).
And UST rose from $0.64 to $0.93.