1. The value adjustment of UST is driven by the arbitrage behavior of users using the on-chain asset Luna.
2. Terra ecosystem also provides a decentralized lending protocol “Anchor”, which can provide high income for users who stake UST and create the main demand for UST in the market.
3. The rate of return provided by Anchor is finally guaranteed by the subsidy of the Luna foundation.
4. However, if the confidence of token holders collapses due to some sudden events and the holders choose to sell LUNA, resulting in the decline of its price, this dual token mechanism will become a spiral leading to destruction.
5. The Luna crash and the rescue action of the project team may become the last stone to overwhelm the entire cryptocurrency market.
On May 4, the Federal Reserve announced an interest rate increase of 50 basis points, which cooled the cryptocurrency market as a whole. As the price of various crypto assets, especially Bitcoin
, fell, the famous algorithm stablecoin UST also exploded. The stablecoin UST was decoupled from the US dollar
. UST fell to 0.69 against the US dollar
on May 10 and to 0.29 on May 11.
Just two months ago, LUNA was one of the most anticipated crypto assets, with prices doubling to a high of $98 in 10 days. It's hard to imagine that even just a week ago, the LUNA price was still at $86.8, while after several rounds of rapid decline, the current LUNA price is only $1.2.
For previous news about Luna's slump, please see: UST Decoupled from the US dollar
and LUNA Slumped by 60%.
Introduction to LUNA's "dual token + stake" mechanism
Terra is the most important layer 1 public chain in the Cosmos ecosystem. It was founded in 2018 and is famous for its decentralized algorithmic stablecoin project. Terra issues stablecoins that anchor multinational fiat currencies, including TerraUSD (UST), and its on-chain native token is LUNA, which has plummeted this time.
As an algorithmic stablecoin, UST does not have real assets as the value support behind it. Instead, it adjusts the supply and demand of tokens through the algorithm, so that the value is always anchored to the corresponding type of fiat currency. Specifically, the value adjustment of UST is driven by the arbitrage behavior of users using the on-chain asset LUNA. Users can exchange one UST for one LUNA with the official use value of $1 at Terra at any time, or one UST for one LUNA with the value of $1. In other words, whenever Terra officially issues a UST, a $1 LUNA will be burnt.
When the UST price is more than $1, users tend to buy LUNA more and convert it into UST, so as to improve the supply of UST in the market and finally reduce the UST price; When the UST price is less than 1 $, users tend to buy more UST and selectively convert it into LUNA, so as to increase the demand for UST, reduce the supply of UST in the market, and finally increase the UST price.
Under normal circumstances, whether the UST price is high or low, the user's spontaneous arbitrage behavior will adjust the UST supply and push the UST price back to the anchor price of $1. In this mechanism, the increase in the total supply of UST means burning more LUNA, causing LUNA deflation, thus raising the price of LUNA.
In addition, the Terra ecosystem also provides a decentralized lending protocol “Anchor'', which can provide income for users who stake UST. The income that Anchor can provide can be as high as 19.5%. Therefore, a large part of the total flow of UST is staked on the Anchor protocol. According to Terra's official data, this proportion has reached more than 90% before, making stake arbitrage the most important application scenario of UST, which has become another key to the growth of UST demand.
Image: Anchor Protocol official website
So how does Anchor provide users with such a high rate of return? The answer is that in addition to charging loan interest, Anchor will also use the assets mortgaged by the lender on the platform for investment. This model worked well in the bull market, but with the continuous growth of UST staking, Anchor began to make ends meet, so it is necessary to mention another important organization under the Terra ecosystem. When Anchor is in deficit, Luna Foundation Guard (LFG) under the Terra ecosystem will subsidize Anchor.
Since March this year, Luna foundation has been purchasing Bitcoin
as a reserve in order to improve the stability of its system through the strong consensus ofBitcoin. By March 26, the value of Bitcoin
held by the Luna foundation had reached $1 billion.
To heaven or to hell
When the development momentum of the project is good and the token holders have sufficient confidence, this "dual token + stake" mechanism is the flywheel of LUNA price rise. By May 9 before the crisis, the total supply of UST had reached more than $18 billion. It was in this process that LUNA prices continued to rise and remain high. However, if the confidence of token holders collapses due to some sudden events and the holders choose to sell LUNA, resulting in the decline of its price, this dual token mechanism will become a spiral leading to destruction.
It can be seen that Terra officials, like the central bank under the Bretton Woods system, provided the final collateral for the issuance of UST, but the collateral that the central bank could provide at that time was real gold, while Terra could only provide the virtual asset LUNA issued by itself. LUNA plays a role in digesting the fluctuation of UST price, but the price of LUNA is determined by the confidence or consensus of the holders in the final analysis, which makes this dual token system more like walking on thin ice. In the sharp decline on May 19 last year, UST was decoupled from the US dollar
, and the lowest price fell to US $0.94. Fortunately, the volume of UST was still small at that time, and LUNA well digested the price fluctuations. In this crisis, the overall market value of UST increased with the issuance of tokens, but the market value of LUNA could not grow simultaneously, which made it difficult for LUNA to serve as the clearing function for UST. However, due to the rapid depletion of the Luna Foundation's reserves, the Luna foundation was also unable to provide final endorsement for the system.
When the black swan incident occurs and LUNA's price continues to fall, so that the market value is lower than UST, the holder's confidence will collapse rapidly, which is what we have seen in this crisis.
Image: also on May 8, LUNA's market value was $20.7 billion tonight, only slightly higher than UST's market value
Conclusion: "death spiral" begins
In fact, on May 8, the news that the UST price began to break away from the anchor price was spread in the crypto community. Meanwhile, the blue whale holding UST has also begun to sell its UST. The Luna foundation also began to respond by selling its own BTC to rescue UST and LUNA. The measures of the Luna foundation took effect at the beginning, but with the further decline of LUNA price, a large number of UST loans mortgaged by bLuna on Anchor were liquidated, resulting in the continuous decline of LUNA and the rapid deterioration of the form. The Luna foundation has been unable to control the situation.
Image: liquidation of Luna No. 10; Source: alpha defi
From the establishment of Anchor to create demand for UST, and then to further push up the price data through the dual token mechanism, the Luna project is undoubtedly successful in marketing. They have attracted a large amount of funds and created a miracle of growth. However, this huge amount of money has now been backfired, which has become a flood for the burial of Luna. Even the collapse of LUNA price and the transfer of Bitcoin
by the Luna foundation in dealing with the crisis may become the last stone to overwhelm the whole cryptocurrency market.
With the continuous development of the cryptocurrency market, the impact on the real world is also expanding. Enron's market value was $80 billion when it exploded in 2001 due to financial fraud. Today, the market value of Luna + UST has reached nearly 40 billion. DeFi may be the source of innovation in the financial industry, but it may also bring destruction. This event deserves our reflection. Is the algorithmic stablecoin really reliable? Are there any other security issues with DeFi? How to avoid the project risk and systemic risk of the cryptocurrency industry as much as possible through more reasonable mechanism design?
Author: Gate.io Researcher: Edward H.
Translator: Joy Z.
* This article represents only the views of the researcher and does not constitute any investment advice.
*Gate.io reserves all rights to this article. Reposting the article will be permitted provided Gate.io is referenced. In all other cases, legal action will be taken due to copyright infringement.
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