Why did Luna crash? What led to terra UST’s demise and how does this relate to Luna? In this article I will walk you through the most significant collision in crypto history to date and what lessons we can learn from it.
Let’s look at what happened
The beginning of Luna’s demise
On the 8th of May the price of UST which had been steadily trading at $1 started to shift.
At first it started trading at around $0.98.
On the 9th it reached a bottom of $0.95.
But, by the 13th of May it had dropped all the way to $0.17.
The third largest stablecoin had lost its peg and collapsed wiping out $47Bn in market cap.
The shock waves have yet to dissipate but we do know that many protocols and additional value were / are being destroyed.
The full extent of the damage has yet to assessed.
Why did Luna UST crash?
Was it bad luck or was it doomed to fail from the start?
Was there a brilliant George-Soros-style trade that instigated it all?
What does this mean for the broader crypto ecosystem? What lessons can we learn?
To understand what happened I’ve studied 12 twitter mega threads and listened to 5.5 hours of podcasts.
In this article I will summarize what caused Terra Luna to derail in the simplest way possible
What is Terra Luna again?
Terra USD is an algorithmic stablecoin denoted as UST.
It is built on Cosmos. If you don’t know what that is check out my article: What is Cosmos crypto.
One UST is supposed to equal one US dollar.
Luna is a crypto token that is deeply intertwined with Terra UST.
Let’s explore how.
Let’s travel back in time to Ancient Rome when people used gold coins for their currency, the Aureus.
Say I have lump of gold that is worth 100 Aureus.
I want to convert it into coins so that I can use my gold to buy stuff.
So I take it to the mint and they melt my coins into 100 Aureus coins.
They take a small fee for doing this.
Let’s move forward in time. Imagine you are a gold miner in California.
You find a lump of gold that is worth $100. You take it to the bank and they give you 100 dollars.
The dollars you have can always be exchanged back into the same value of gold.
Now fast forward by about another 140 years to get to today.
In the modern world everything is digital.
Say I have $100. I can put this amount in a digital mint and get 100 stablecoins where the value of the stablecoin is $1.
This is great! I now have a coin that I can use on blockchains.
How a basic stablecoin works
What I have just described is how the stablecoin called Tether (USDT) works.
Whenever I want I can give my stablecoins back to the mint and get my $100 back.
Tether’s stablecoin is like a certificate of deposit or IOU that I can use to claim my $100.
So far so good.
Like Tether, Terra is (was) another stablecoin pegged to the US dollar.
Now think of the mint being like a magic box.
Like before, someone takes your $100 bill and gives you 100 UST.
However, instead of leaving the $100 in the box they remove it and replace it with 100 magic beans called Luna.
The owner of the box says “don’t worry, if you ever want your $100 back then you can convert UST into Luna and the subsequently sell the 100 Luna for $100 on any exchange. 1 UST will always be worth $1 worth of Luna”
Whoa! What just happened here?
What’s up with taking my dollars and replacing them with funky beans man?
Why not just keep my dollars in the magic box for when I need to cash-in my UST?
“Ahh my friend!” Terra-Luna says. “Because this way I can do some magic called an algorithm”
“What kind of wizardry is that?” I ask.
“It’s simple really. Let’s say UST has depegged and trades at $0.98. You can buy 100 UST for $98 and trade it for $100 worth of Luna. 1 UST will always be equal to $1 worth of Luna. This way you make a 2% margin. Many people will do this and push the price of 1 UST up to a dollar again. A similar opposing trade can be made if UST exceeds a dollar. “
“But if UST is trading at 0.98 wouldn’t there be only 98 Luna in the box ?”
“Ahhh my friend…here is where the magic comes in. Yes there was only 98 Luna in the box. But I have minted another 2 out of thin air. You see I can add (mint) or remove (burn) Luna as I please. And this way I can incentivize the market to always trade 1 UST for 1 dollar.”
“Why that is brilliant!” I exclaim.
If you still have doubts on the mechanics then I would suggest reading my simple explanation about Terra Luna.
Why did Terra Luna crash so hard?
Terra Luna entered a death spiral.
This how a death spiral works
Say UST lost its peg for whatever reason.
Say a large holder sold a large amount of UST pushing its price down. There are many who believe that this large holder was 3AC, the now infamous crypto fund.
To counteract this, the algorithm mints and sells more Luna.
You can only buy new Luna with UST.
In theory then, arbitrageurs will buy UST at 0.98 and sell it for $1 worth of Luna.
The buy pressure on UST should prop its price up.
But what if people start to think that might not happen? The market is not always rational.
As more Luna gets printed it pushes Luna’s price down. All this can happen very fast.
If the price of Luna is dropping like a knife people start to panic.
Everyone is in sell mode and no one believes in the magic anymore.
Why did Luna derail and how did UST enter a death spiral?
There are 3 main narratives that the community and analysts estimate led to the death spiral:
- Anchor protocol, timing and bad luck
- A conspiracy theory around a deliberate attack
- Structural issues
1. Anchor Protocol, timing and bad luck
According to this narrative timing was a key factor.
If UST had depegged at any other time they may have been able to save it.
In fact, Luna had deppeged in the past and had managed to survive.
Shortly before the depeg there were two important events we should describe.
i) Bitcoin used as backing for UST
The first is that the Luna Foundation Guard (LFG) purchased a large amount of Bitcoin.
In the last half of March they raised funds from VCs and in combination with their own funds purchased close to a $3.5Bn worth of Bitcoin. Their aim was to have purchased a total of $10Bn worth of BTC by the end of the third quarter of 2022.
This meant that UST was now approximately 80% backed by Luna and 20% by BTC.
This gave UST more gravitas. It was no longer merely backed by Luna magic beans but something way more serious.
Apart from serving as a huge PR stunt Luna was now also more attractive to Bitcoin maxis.
The criticism to this way of thinking was that LFG was trying to back a stable asset with an unstable one. Bitcoin is famous for its wide fluctuations in price.
Note, however, that there are some stablecoins that do precisely this i.e. they use crypto assets to back their stablecoin.
DAI is one such stablecoin where More than one dollar’s worth of ETH backs each DAI.
The difference is that DAI is over-collateralized to account for fluctuations in the price of ETH.
So for example each DAI might have $1.5 worth of ETH backing it. Hold that thought.
ii) Curve pool transition
The second event is that in early April, Do Kwon, Terra Luna’s founder, announced that they would be moving funds from 3-pool to 4-pool on Curve.
Curve is a decentralized exchange for stablecoins. On the exchange there are various pools of stablecoin combinations.
For example, there is a pool for (DAI, USDT) where you can swap DAI for USDT.
The exchange is very liquid and offers very attractive fees.
For reasons that are beyond the scope of this article Do Kwon wanted to transition from the (UST, USDC, USDT) pool to a (UST, USDC, USDT, FRAX) pool.
Close to the time of the depeg he had started shifting liquidity from 3-pool to 4-pool.
So they drained the pool that was supposed to support UST with liquidity since it was transitioning to the new pool.
The final component to this narrative is the Anchor protocol.
This a protocol that allowed you to take your UST and earn close to 20% in interest. This rate of return was small when DeFi was on fire. In early days of the bull run it was easy to earn way higher interest rate on your stablecoins. But as the market started to cool off stablecoin returns on protocols such as Yearn were below 2%.
Suddenly Anchor was massively attractive to people.
Why keep cash in a bank account earning 0% interest when you can convert it to a stablecoin and earn 20%.
Imagine those people who had successfully sold their crypto for a profit and had their cash sitting in stablecoins.
All they needed to do was convert it to UST and transfer it to Anchor.
How was Anchor able to support such high interest rates?
Anchor was also a lending platform.
So borrowers paid interest to lenders.
But that wasn’t enough to support the high savings rate.
Anchor also earned income from staking assets on other blockchains.
Again this was not enough to support the 20% interest rate.
This meant that LFG needed to subsidize Anchor.
You can think of this as a marketing budget that LFG used to attract users to purchase UST.
LFG used the commissions it received during the minting process to fund the subsidy.
The 20% interest rate was so attractive that at one point almost 80% of all UST was on Anchor.
This meant that LFG was going to run out of subsidies within the next 3 months after which interest rates were expected to drop to closer to 15%.
Anchor as a stablecoin utility
The whole motivation behind deploying the Anchor protocol was to create some kind of utility for UST.
It is important to understand that LFG envisioned UST being the decentralized stablecoin of the crypto world.
Backed stablecoins such as USDT are not decentralized as they rely on an intermediary to manager real cash and cash equivalents.
But for UST to have demand there must be some reason to use it.
For example, Egyptians use the Egyptian pound because it is a medium of exchange in the country.
The government collects taxes in it, pays the public sector with it and so on.
LFG wanted UST to become the medium of exchange in the crypto world.
But to do this you need to have an ecosystem that entices the use of UST.
Anchor was thought to be the first step in achieving this.
The bad luck narrative
Here is how this narrative is thought to have played out.
The Curve 3- pool starts getting depleted as it transitions to 4-pool.
Concurrently, some big UST sells happen that slightly depeg the stablecoin.
The more panicky people on Anchor start withdrawing and selling UST.
On Anchor not everyone can withdraw at once. To prevent bank runs there is a time freeze of about 24 hours. This is a bad design because it makes people even more nervous.
Pressure and panic build. At the same time BTC price is dropping because the market is in a down cycle.
LFG bought BTC at about $40K. It has to sell BTC at a loss in order to prop up the price. This is further putting downward pressure on the price of BTC.
Everyone panics and wants out.
People are selling UST at lower prices because they no longer trust or completely understand the LUNA – Terra mechanics. Traders then start to short Luna and UST which further tanks prices.
Next, centralized exchanges ban UST withdrawals and mega panic kicks in.
Meanwhile Luna is getting printed at a crazy rate to prop up the price. But effectively Luna is crashing. Luna inflation reached 18,000%.
Eventually the peg cannot be supported and UST crashes all the way down to 17 cents.
2. Conspiracy theories around Luna’s
Who killed JFK? Are vaccines effective? Was the moon landing fake?
Conspiracy theories often accompany major events. People need to know the truth and apportion blame to something.
Below I will describe one scenario that crypto Twitter thinks is plausible but for which there is no hard evidence of yet.
The attacker is said to have borrowed 100,000 BTC to start a short position.
A short position is just a trade where you bet that the price of the asset will fall in the future.
They then sell this BTC to LFG when LFG makes its massive Bitcoin investment in early March.
With the price of BTC being around $42,000 at the time this translates into a $4.2Bn short position.
The attacker also has purchased $1Bn in UST. You can see already that this scenario is looking a little extreme.
Next LFG starts draining 3-pool of $150Mn.
The attacker also starts selling $350Mn worth of UST, draining liquidity further.
LFG continues the transition to 4-pool and drains a further $100Mn.
As a result UST depegs to 0.97.
This forces LFG to start selling BTC to prop the price up thus putting downward pressure on BTC.
At this point the attacker sells another $650Mn of UST on Anchor.
This causes everyone to go into panic mode on Anchor. Everyone wants to get out.
Meanwhile LFG continues to sell BTC to defend the peg.
Chains have become so congested though that centralized exchanges suspend withdrawals of UST.
UST enters a death spiral while the price of BTC falls 25% resulting in $952Mn in profit for the short trader.
While the timing of the event around the Curv pool transition seems suspicious there is currently not strong enough evidence for the attack.
3. Structural issues leading to Luna’s crash
A theory put forward by @gametheorizing is that the main reason for the collapse was structural. According to this argument, the underlying reason is that the dollars I put into the magic box are not all there.
Let’s revisit our previous example.
Say I buy 100 UST. My $100 goes into the magic box and in return I get Luna.
What happens to my dollars? Well some of it goes to LFG. LFG gives LUNA and gets $50 USD.
Great, these guys effectively have my dollars. The other $50 goes to investors.
Oops! These guys have no incentive to hold their dollars.
They might spend it on beer or do whatever they want with it.
So now you have 100 UST that are effectively backed by $50.
The higher the price of Luna the larger the asset liability mismatch.
According to this narrative the asset / liability mismatch was bound to cause the depeg.
While not the key causes, Anchor and the BTC purchase (and subsequent price drop) only exacerbated the situation.
What does Luna’s crash mean for the broader crypto ecosystem?
We still don’t know the the full repercussions of Luna’s crash
We do know that many other protocols were affected.
For example, people started pulling their liquidity out of algorithmic or pegged liquidity coin pairs from exchanges.
Why, even USDT depegged for a while as people panicked.
Many other entities were affected though.
For example, Venus Protocol saw $13.5m in damage because the price feed (known as an oracle) stopped updating the price of Luna below $0.1.
Imagine! When the price of Luna was $0.01 borrowers could provide Luna and borrow 10 times more than the protocol intended to initially.
The same happened with many other protocols wiping out a lot of value.
There was also a bunch of protocols that had invested in UST given that it was the third largest stablecoin.
For example, Celsius Network, a centralized borrowing and lending platform, also significantly invested in UST.
I expect that slowly funds and protocols will start announcing big losses as a result.
There is also the infamous case of Kava platform that lost about $300Mn because it had hardcoded the price of UST at $1.
Users were able to mint the Kava stablecoin against UST (which was close to 0) at an almost 1:1 ratio which they subsequently used to purchase other assets.
What lessons can we learn from the Terra Luna crash?
Laura Shin has an excellent podcast with Tascha Che where they discuss 5 lessons learnt from the Terra Luna crash
Tascha says that one should think about the stablecoin business as that of transforming volatility.
Users want a stable value so they exchange a volatile asset for a stable one.
In many ways the stablecoin issuer is like an insurance company that is willing to absorb volatility.
Lesson 1: Assets that “back” a stablecoin need to have uncorrelated demand
Terra Luna was not a failure purely because it was under-collateralized.
If you look at countries, about 40% of them maintain a currency peg to the US dollar.
But they do not back their currency 100% with dollars.
So why did Luna fail while countries don’t?
The main reason is that demand for a country’s currency is uncorrelated with the demand for a stable asset.
Fiat countries have a sovereign economic system where the currency serves as a store of value and medium of exchange.
Local transactions, tax payments, public sector salaries mean there is a natural floor to the demand for these currencies.
Online stablecoins do not have that.
Compared to a country the Luna ecosystem was very small.
The largest player in this ecosystem was Anchor.
Granted there was some DeFi activity but it was comparatively small.
Anchor drew people in fast without actually creating a network effect.
A stablecoin is purely a utility product with 0 network effect.
With a fiat currency, if the currency does not maintain the peg it’s usually not the end of the world.
With Luna if you removed the peg it was game over. There was no other reason to hold Luna.
For these reasons it would have been better to hold blockchain native tokens such as ETH, SOL , AVAX that have an uncorrelated demand.
Lesson 2. Luna failed because it grew too fast without any network effect
People say there was a lot of reflexivity built into the Terra Luna equation.
This means that if demand for UST goes up then the price of Luna increases which makes it worth more UST which leads to more UST minting.
It is a virtuous cycle until it isn’t. When UST’s price drops it pushes Luna supply up causing Luna to drop etc.
Terra user activity grew due to Anchor offering attractive rates but this does not mean that its network effect was growing.
While it lead to some projects being built the very fast growth in users was mainly subsidized.
Once those subsidies ran out there would be no reason for people to stick around.
Lesson 3. Focus on the network effect for the reserve asset, not for stablecoin itself
Every L1 blockchain introduces and tries to scale their stablecoin.
But stablecoins only offer utility. They do not really have a network effect.
If the stablecoin depegs no one wants it so zero network effect there.
Instead, Tascha says one should focus on the network effect of the reserve assets.
Lesson 4. Luna got too big too fast
It would be preferable to have a healthy ecosystem with 10 – 20 stablecoins rather than 3 mega stablecoins dominating the market.
This reduces systemic risk.
Smaller stablecoins would be easier to bail out than massive ones.
For example, Luna did try to find a private a bailout and failed.
Lesson 5. Need for Regulation
Luna grew too big too fast without there being a lender of last resort to save them from bankruptcy.
Had regulation been in place there may have been minimal capital/liability ratio requirements.
This would have prevented Luna’s undoing and would have saved many users from losing their money.
The industry could think about self regulating somewhat like banks do with Basel accords.
After multiple banks collapsed in the 70s the banking sector came together and agreed upon certain standards: capital ratios, leverage ratios, liquidity ratios and so on.
Complying with these standards is voluntary but has become the norm and is a signal of trust.
Wrapping up the Luna collapse
In hindsight, the critics of Terra Luna’ stablecoin experiment were right.
People ask will there ever be another attempt at an algorithmic stablecoin? The answer is probably yes.
Being able to mint money out of thin air bestows a lot of power to the entity that is minting. People will continue trying to achieve this.
What’s next for Luna after its debacle?
Terra Luna seeks to regenerate itself. The old versions of Luna is not called terra classic and new Luna will be issued to investors.
It remains to be seen wether Luna will rise up like the phoenix or die again.