What is the risk of UST decoupling and LUNA death spiral?

Algorithmic stablecoins always raise doubts about their decoupling.

MakerDAO co-founder Rune tweeted on January 4 that Terra ecological stablecoin UST and abracadabra ecological stablecoin MIM are solid ponzis.

There is currently $10 billion in hot money in the Terra ecosystem, with daily on-chain withdrawals capped at $100 million. Twitter user 0xHamz posted a description of a possible UST decoupling and a worst-case scenario for the LUNA death spiral. The details are as follows:

1. Terra is a decentralized blockchain designed for algorithmic stablecoins.

This ecosystem operates between two tokens, UST and LUNA.

  • UST is a stablecoin that aims to be pegged 1:1 to the US dollar
  • LUNA is the governance token

LUNA is seen as the present value of UST’s future use cases.

2. UST is 100% unsecured and targets algorithms through incentives.

To mint/create UST, you have to deposit into LUNA and then destroy it.

UST has seen explosive adoption recently.

vwVpcQ4FUT61GWLQxuHSP2vnzjGfw5VJCjckuKMJ.png3. The result is: LUNA circulating supply is significantly reduced due to burning, 5% of token supply is burned within 1 month.

PuhT5RCS2F894xNRcLGNym2ETbys27epzb5vhW4o.png4. 90% of UST uses deposits and borrowing from Anchor – Terra’s money market platform.

Anchor ‘guarantes’ 20% APY and it competes with other stablecoin yield farming opportunities on CVX.

Who doesn’t want a “guaranteed” 20% return on their stablecoin?

2n5JzRMbrZ5CHGdTMdgNcqS0L27bcpWOXCbuXKbb.png

5. The key to UST growth is the Abracadabra degen box, which added 1.4 billion UST and was “sold out” immediately

Bm7eUk51cn5QOjPSKYOHl37NOV5jUHhXMwGzEnLz.jpeg

6. Anchor pays depositors:

  • The loan interest rate charged to the borrower
  • Staking Rewards for Mortgage Borrower Deposits – Mainly LUNA

for most of 2021

  • Anchor pays borrowers to borrow UST
  • burn LUNA
  • Raise LUNA prices
  • Allow borrowers to take advantage of leverage

    yO8jFR8TBqyrnO4NZpXxxNk9fMAEitoLSlngbTbi.png

7. Now, Anchor essentially lets you borrow UST for free

This is great for LUNA because UST creates LUNA burn

8O6ShWQNKIK7H1WWTHDlhb8cnjdzgGsHZ3tlPVnM.png

8. But demand deposit APY is withdrawing reserves

Anchor needs to lower its deposit rate or find more ways to stimulate more borrowing.

2ozRQGJdN4WlB6sZRNWbeOzLIkmgrjKSaIXW7sro.png

9. Before Anchor needs to adjust deposit and loan interest rates, depositors currently only have a guarantee period of 80 days

V2dYpApVXWA3xh23Z91lslXppFiIu8szq5Smpexh.png

10. Changing the deposit rate may result in the loss of funds to other chains because:

  • Selling UST requires minting LUNA
  • This will cause the price of LUNA to drop
  • LUNA price may drop to levels that liquidate borrowers
  • Fewer borrowers means fewer sources of funding to fund deposits APY

11. When borrowers borrow UST, they deposit bLUNA, which is LUNA pledged and routed through the LIDO system

Given how unreliable the peg is, the ratio of bLUNA to LUNA matters

In May 2021, in about 3 weeks you can exchange 100LUNA for 110bLUNA and burn it to receive 110LUNA

BYbvguDWCAB3z6IZ1KwtGmV8y5k72vSHjFtgTFJa.png

12. Given Anchor’s leverage and maximum liquidation threshold, the LUNA system is highly vulnerable to liquidation at the $55 level

RbCJTncm0DK1m05lCUsv3H5HsayTu9U3P8RzSpqG.png

13. But the UST/LUNA swap is capped at $100 million and the spread is 0.5%.

Larger redemptions could happen, but their spreads would grow exponentially

In May 2021, LUNA/UST had 80 million cancellations at the peak, which exceeded the redemption cap of 20 million, and the interest spread exploded by 7-8%.

14. When the spread breaks out, the UST peg is effectively broken

UST decoupling $1 creates 2 arbitrage behaviors:

  • Buy at 94c, wait till $1, get 6%
  • Buy UST at 94c, convert to 100c LUNA, sell LUNA to USDC and repeat

Once the UST is decoupled, the ecosystem will be reflexive

15. If we enter the high/mid 50+ cascading liquidations and withdrawals from UST, using the May crash as a comparison, LUNA could reach $35

At that level, LUNA market cap could fall below UST, creating a vicious minting/burning dynamic

43ZLyXG3xM3ujKwGQip2QOzBHkFoBrRVK3DEr5Ux.png

16. Going further, see how volatile the LUNA/UST market ratio is

The correlation between LUNA and UST market cap is around 0.80

HCefvG5LCVdi5wsIErfkvW7xkRH9n9pYOJ5dsbXL.png17. The process is as follows:

  • Volatility causes LUNA price to drop
  • LUNA price drop causes anchor liquidation
  • Redemption exceeds $100 million cap, spread widens
  • Spreads widen, LUNA prices fall

Buy cheap UST, redeem LUNA when the spread is favorable, sell LUNA at market

18. How to make money in this process?

  • Short LUNA perpetual futures once LUNA crosses $60
  • Buy bLUNA and convert to LUNA
  • Buy UST and convert LUNA when peg breaks

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/what-is-the-risk-of-ust-decoupling-and-luna-death-spiral/
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