LUNA Freefalls , UST Depegs, Is this end of Terra?

“Everyone, deep in their hearts, is waiting for the end of the world to come.” ― Haruki Murakami, 1Q84

Inflation rates soared as high as 8.5%, voices of interest rates rising can be heard all around, “25 basis points, 50 basis points, 75 basis points…”

Just today, people are witnessing their self-prophesized doomsday as interest rates rise and markets tanked sharply. Headlines are all describing how global stocks are suffering the worst days, and the VIX volatility index has reached an all-time high since the COVID-19 outbreak.

What happened to LUNA?

During 8am this morning, many leveraged positions were liquidated due to the decline in LUNA’s price. The collapse has triggered a long-anticipated death spiral. LUNA’s price was last seen at $29 thereabouts, and UST’s price depegged close to $0.65.

Death spiral? What’s that?

The design of LUNA and UST is a giant positive feedback loop. LUNA price decline leads to UST being sold off which leads to more LUNA being minted which causes LUNA price to decline (goes on and on)

Read here to find out more about how LUNA and UST minting mechanisms work.

What exactly happened?

We need to travel back to 8th May to get a clearer picture.

On the night of 8th May, Twitter account WhaleTrades has alerted numerous UST selloffs every hour, and they are all sold in the millions.

Due to the selling pressure, UST has shown some signs of depegging. Furthermore, the UST-3Crv liquidity pool has also showed some liquidity imbalance.

Upon reading till this point, you might be wondering, why would such “small” selloffs threaten UST’s dollar peg? Bear in mind, UST has a market cap of $17 billion.

No doubt, UST is currently the largest algorithmic stablecoin. Theoretically, it does have the ability to withstand the minimal selling pressure. However, UST is very strongly related to, and you guessed it: Anchor Protocol.

As of 5th May, Anchor’s total value locked (TVL) reached $18 billion, which accounts for all the the market cap of UST. In other words, everyone who held UST had them deposited into Anchor.

Due to poor market returns caused by unstable market conditions, everyone, regardless whale or user, is turning to stablecoins as a safe heaven. It seems like a no brainer to convert assets into UST and depositing them into Anchor Protocol, which offers a supposedly stable and relatively high APY return.

What’s wrong with this?

It may seem like UST and Anchor have marketed well with these claims, but I feel that it may very well be the cause of death for the Luna Foundation Guard (LFG) and Terra ecosystem.

With the plethora of decentralized finance protocols out there, it is not uncommon to see people “looping” the protocol as an attempt to leverage their UST positions (see example from Planet Finance). This burns an even greater hole in Anchor’s already dwindling yield reserves.

What needs to be done?

In order to prevent UST from losing its dollar peg, LFG needs to ensure that the 18 billion UST in Anchor protocol is not excessively withdrawn (bank run scenario), as there is little to no liquidity available for UST in the markets. Nevertheless, clever whales have identified this and started to migrate their funds.

The minor depeg on 8th May has negatively affected holders of LUNA and UST. On 9th May, Anchor experienced large withdrawals, further pressuring the UST’s dollar peg. LFG realized this and immediately posted a Twitter thread with their proposed solutions and timeline updates.

9th May 11:56 – Loan out BTC to protect UST's dollar peg

- LFG released a statement stating that they are loaning $750m worth of BTC to OTC trading platforms, in order to protect UST peg. As market condition stabilizes, LFG will loan $750M of UST to accumulate BTC.

9th May 13:17 – Reassured that they are not exiting their Bitcoin positions

- LFG has voted to deploy $1.5B in capital ($0.75B in BTC, $0.75B in UST) in order to alleviate the market's concerns around UST, and emphasizing that LFG is not intending to exit its Bitcoin position.

10th May 04:47 – LFG deposited 28205 BTC, worth $840M

- This morning, LFG withdrew 42,530.8 BTC, worth $1.27B. Subsequently, it deposited 28205BTC worth $840M.

10th May 08:50 - LFG withdrew the remaining 28205 BTC, depleting reserves

- Reserves are now empty. See here.

LFG’s relief attempts saw UST’s peg recover slightly on 9th May, but fear among the crypto markets continue to loom. Subsequently on 10th May, the markets witnessed a bloodbath as LUNA continues to experience another blow. According to DeFi Alpha, the first large-scale liquidation will happen when LUNA reaches $42, followed by $35, then $29…

The Freefall

Just this morning at 7am, the inevitable happened. LUNA fell below the liquidation price of $42, and UST started to lose its dollar peg. After half an hour, LUNA's price fell below $35, the 2nd liquidation price point, and UST declined till $0.85. Currently, LUNA's price fell to $29, resulting in yet another liquidation event, with UST decliding till $0.69. The LTV was reported to be as high hundreds of millions of dollars.

LUNA's decline in price and UST's depeg has caused a destruction to Terra's ecosystem. The total TVL has fallen 50% to around $11.98B, with the top few protocols losing on average 50% of their TVL.

According to CoinMarketCap's data, UST's market cap has declined close to $4B in the span of a few hours, hovering around $14B as of now.

As of now, there are only $6B UST left in Anchor's deposits, indicating that there are $8B UST out in the markets, possibly getting sold as we speak. In order to attract users again, Anchor's APY has been adjusted to offer more than 20% APY.

Conclusion and Personal Thoughts

This is not the first time UST has depegged and underwent a death spiral. During 19th May last year, UST had also lost its dollar peg, falling to $0.85. After some help from LFG, LUNA and UST were able to continue developing. Since then, in order to prevent such events from happening again, LFG has made some changes, which includes revamping UST's endorsement mechanism.

As a matter of fact, purchasing BTC and other L1 tokens as a form of endorsement is not necessarily a wrong decision, however this requires some time for the new mechanism to achieve its full effect. Sadly, the markets did not give Do Kwon and LUNA maximalists enough time to redeem themselves, resulting in this catastrophe.

What will LFG do now? Will we ever regain enough confidence to use UST again? For that, we can only wait and see. Be sure to follow Do Kwon or LFG’s Twitter for the latest updates.

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