From May 8, 2022, the UST broke off the anchor slightly and ran “underwater” for a long time, causing market panic. The giant whales continued to sell UST, and finally formed a death spiral. The lowest price of UST hit $0.21, and LUNA disappeared.
The positive feedback mechanism of LUNA-UST determines that when accidental factors cause the market’s confidence to collapse and UST breaks off, it has no inherent stability mechanism to return it to a “steady state”, it must be guided by LFG’s expectations or real money. Therefore, it is extremely dependent on LFG’s role as the “lender of last resort” and the actual strength of the “lender of last resort”, which is full of uncertainty.
UST is backed by LUNA market capitalization, and the two share liquidity. However, the excessively fast issuance speed and price-feeding mechanism of UST accumulated a huge amount of insufficient minting debt during the rising cycle of LUNA, and started a death spiral during this falling cycle. LFG may have also realized the problem of price support and introduced BTC to strengthen liquidity, but the market did not give UST time.
From the UST crash, it can be seen that the biggest risk to stability is user confidence. Once users lose confidence and start panic selling, it is very easy to trigger a death spiral. The main reason for users losing confidence is the lack of stable collateral. The collateral of UST is essentially LUNA. It is neither as high consensus as Dai’s collateral ETH, nor as stable as Frax’s collateral USDC. Originally Terra still had a chance, but Do Kwon’s wrong choice led to the rapid expansion of the market value ratio of UST/LUNA, dragging both into the abyss of doom.
1 LUNA—UST’s Dual Currency Spiral
2 The volume of UST to be “digested” is huge
3 The market capitalization of LUNA and UST is seriously inverted
4 The death spiral of LUNA-UST
5 UST’s price stabilization mechanism is vulnerable
6 LUNA—The end of UST
In just a few days, the star project in 2021, LUNA with a market value of nearly $50 billion (41 billion), fell from heaven to hell, the market value plummeted to $100 million, and the price fell from a high of $119 to 0.01 U.S. dollars, tens of billions of dollars were wiped out, historically known as the “512 Massacre”, but the epicenter of this earthquake was the world’s largest exchange, Binance, and the epicenter was the danger that created several algorithmic stablecoins (Basic Cash). Korean man – Do Kwon.
So, what is the reason for this tragedy? What is the mechanism? What is the future of LUNA?
LUNA—UST’s Dual Currency Spiral
To understand the first tragedy in the cryptocurrency market in 2022, we must first understand the dual-token mechanism of LUNA-UST.
UST is a stablecoin on the Terra chain, and the equivalent value of UST can be minted by burning $1 of the on-chain token LUNA, and vice versa.
The arbitrage mechanism of UST is reflexive. When the price of UST is higher than the peg value (USD 1), users can burn LUNA of USD 1 and mint 1 UST, which will return to peg by increasing the supply of UST; otherwise , when the UST price is lower than the anchor, the user can burn 1 UST and get 1 USD LUNA.
UST is mostly stored on Anchor. Anchor is a lending protocol on the Terra chain, which is equivalent to the official bank on the chain. By providing super high APY, it attracts users to deposit a huge amount of UST, which greatly increases the supply of UST.
The volume of UST to be “digested” is huge
UST once had a market cap as high as 18.6 billion, most of which was stored in Anchor for nearly 20% APY, and UST’s peak deposits in Anchor exceeded $14 billion. In addition, UST deposits are much larger than borrowed. This means that the actual circulation and usage rate of UST is not high. On average, at least 80% are locked in Anchor, like a “dammed lake”.
The market capitalization of LUNA and UST is seriously inverted
In theory, since UST is minted through LUNA, to ensure the stability of UST, the market value of LUNA must be at least as high as the market value of UST. When the market value of UST is smaller than the market value of LUNA, the margin of safety is higher.
However, as of May 12, 2022, the circulating market value of UST is about 8.7 billion US dollars, while the current circulating market value of LUNA is only 100 million US dollars. LUNA/UST has been seriously insolvent and is in a desperate situation.
The death spiral of LUNA-UST
When the market value of UST and LUNA are inverted, UST will inevitably de-anchor. The de-anchored UST is discounted in the secondary market, but according to Terra’s on-chain mechanism 1 UST can still be exchanged for 1 USD of LUNA. This will lead to a large number of users exchanging and selling LUNA on the chain. In the process of the run, the price of LUNA will be under huge downward pressure, and then the market value of LUNA will drop faster than UST, resulting in more serious de-anchoring of UST and more panic in the market, forming a vicious circle.
Further, the positive feedback mechanism of LUNA-UST determines that when accidental factors cause the market’s confidence in it to collapse and UST breaks its anchor, it has no inherent stability mechanism to return it to a “steady state”, and it must rely on LFG’s expectations. Guidance or real money to stabilize, so it is extremely dependent on LFG’s “lender of last resort” role and actual “lender of last resort” strength, full of uncertainty.
Since May 8, some giant whales have sold about 300 million US dollars of UST, causing it to break off slightly. It may be that the UST has not been anchored for a long time, and the giant whales of the million dollar level have fled one after another. The thin circulating market of UST cannot withstand continuous selling pressure, which eventually caused the flash crash of UST, and also brought down the price of LUNA. form a death spiral.
While Anchor had raised interest rates to 19% in an attempt to retain users, Anchor kept losing savers as panic spread. At present, the market value of UST is about 8.7 billion US dollars, and the UST lock-up volume in Anchor is less than 3.3 billion US dollars, which means that more than 4 billion US dollars of UST are still in circulation, which will form a continuous selling pressure on the price of UST.
UST’s price stabilization mechanism is vulnerable
The liquidity of LUNA/UST is shared, and UST itself is endorsed by the market value of LUNA, so LUNA can be counted as an asset on Terra, and UST is a liability. When the market value of LUNA is greater than UST, the asset value is greater than the debt value, and the system is safe. However, the speed of UST’s additional issuance is too fast, and too many risks have been accumulated, and it is now caught in the dilemma that the value of debt exceeds the value of assets by about 8 billion.
There are two main issues with UST price support. First, assuming that LUNA is bought for $10, and then rises to $20, during the appreciation process, because it is a small sample price, it does not need to change hands completely, so the required capital is less than $10, but it can mint 20 UST. The assets in the system have increased by less than $20, but the debt has increased by $20. During the rising cycle of LUNA, such insufficiently minted debt will be gradually accumulated until it is released centrally during the falling cycle.
Second, minting UST is equivalent to selling LUNA to the system, but in the process of selling LUNA, since the price of LUNA has not fallen, UST is minted according to the market price of LUNA through the oracle machine, so the minted debt is actually greater than the asset value of. Theoretically, the system should have a certain margin of safety. In the process of minting UST, by consuming more LUNA, hedging the falling price of LUNA after the sale, and pushing up the market value of LUNA, to ensure that the asset value is always greater than the debt. The excessively fast issuance rate of UST and the price-feeding mechanism have accumulated risks, leading to the outbreak of a death spiral.
Terra may have also realized the drawbacks of its price support mechanism and introduced foreign exchange reserves. As an algorithmic stablecoin, a centralized stablecoin cannot theoretically be Terra’s choice. Therefore, LFG purchased 1.5 billion US dollars of BTC as an asset endorsement. In essence, it wanted to tie UST and BTC to the same chariot. Trying to expand the liquidity that the system can share.
But before the establishment of a new endorsement mechanism with BTC, UST was tragically de-anchored. It now seems that Terra’s move to introduce BTC is more of a risk warning. At present, LFG has liquidated all BTC to support the market, but the difference in market value between UST and LUNA is still a drop in the bucket.
The end of LUNA-UST
Judging from the current situation of UST, the biggest risk for stability is user confidence. Once users lose confidence in the stablecoin, panic will spread rapidly, and then continue to sell stablecoins, triggering a death spiral.
The reason why users lose confidence is that the collateral behind the calculation stability is insufficient. When the market fluctuates violently, it is easy to trigger large-scale liquidation or redemption. The huge amount of selling will bring an unbearable blow to the currency price. UST is minted by burning LUNA, which is fundamentally the collateral for UST. In contrast, Dai’s collateral is ETH, which is one of the assets with the highest consensus in the market, and has a very high mortgage rate, which can ensure the stability of the currency price even in large-scale liquidation. Frax, another well-known stablecoin, also has USDC with a high mortgage rate. Although USDC has been criticized for being centralized, USDC is the most transparent stablecoin in the market. When the market fluctuates violently, LUNA cannot play a role in maintaining user confidence like ETH, USDC, etc., which leads to the current situation.
Terra’s own strategy is not a problem. With the expansion of the project, it gradually reduces the unsustainable yield in Anchor and introduces BTC as asset endorsement to establish a deeper correlation between UST and the encrypted asset with the highest consensus to enhance user confidence, Prevent runs.
In the early stage of UST anchoring, although the endorsement mechanism of BTC has not yet been deployed, there is still a silver lining.
First of all, Terra decisively closed the casting channel, otherwise there will be a large number of secondary market players arbitrage on Terra. Rather than being earn money that can’t be returned, it is better for the official to arbitrage and bring the money back to LFG. Use limited funds to stabilize the market value of LUNA as much as possible, and let the long and short sides play freely on UST. Even though the price of UST may be very bad, its asset value has stabilized and its debt value has shrunk. As long as the two can eventually converge and a portion of UST is guaranteed to be rigidly redeemed every day, users can continue to maintain confidence in UST.
Second, significantly increase the borrowing rate of UST on Anchor and other lending agreements, increase the cost of short UST borrowers, and force them to repay as soon as possible, otherwise they will face high interest, thereby creating some UST buying.
Unfortunately, Terra does exactly the opposite. At present, the result of opening the recasting channel is that the liquidity of LUNA continues to escape, the depth is getting shallower and the slippage is getting bigger and bigger. The market value falls rapidly with the price of the currency, and the more it falls, the less the circulating market. UST still has about 6 billion in stock, and it is almost impossible for LUNA to hold it.
In addition, the plummeting market value of LUNA will also pose a threat to the ecology on the Terra chain. If the pledge value of the node is much lower than the value of the fund pool, it may lead to a large number of node attacks, resulting in huge ecological losses. If security cannot be guaranteed, what is the point of a public chain?
At present, LUNA is still continuing its issuance behavior, and the price of UST is also plummeting. There is a high probability that another tombstone will be added to the cemetery of the algorithmic stablecoin.
As for what kind of algorithmic stablecoins can be successful, it will be discussed in our follow-up reports, so stay tuned.
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