Why is LUNA in a death spiral?

In the case of the overall downturn of the crypto market, UST has been seriously de-anchored, and LUNA’s 24-hour drop of more than 60% has become a typical event that the market pays attention to.

TerraUSD is trading at $0.742449 today with a 24-hour trading volume of $5,539,349,043, according to coingecko data. UST prices are down 25.5% in the past 24 hours. It has a circulating supply of 18 billion UST coins and a total supply of 18.4 billion. According to the market, LUNA fell by more than 60% in 24 hours.

In response, Do Kwon, founder of Terraform Labs, which powers the Terra blockchain, is taking steps to shore up its algorithmic stablecoin. The Luna Foundation Guard, an association created to support decentralized tokens and the Terra blockchain, says it will release about $1.5 billion worth of bitcoin after TerraUSD falls below $1 as the cryptocurrency market continues to tumble Coin and TerraUSD loans to help strengthen the peg to TerraUSD. 

So, what is the internal mechanism that led to the rescue of the Luna Foundation Guard Association when UST was seriously de-anchored and LUNA fell into a death spiral?

Ecological composition of Terra

To put it simply, Terra (token Luna) is a public chain ecosystem built around stable coins. Its business goals can be summarized into two points: to promote the prosperity of the Terra public chain, and to provide a platform for the development of the Web3 economy for open finance and other applications; Promote the large-scale adoption of its stablecoins represented by UST (an algorithmic stablecoin), replacing centralized stablecoins such as USDT and USDC. Whether it is a stablecoin or a public chain, the project party can benefit from its development and indirectly tax (rent-seeking). Terra also successfully got out of the circle through the stablecoin + public chain model.

Terra deeply binds its stablecoin to the public chain business. Specifically, Terra’s public chain ecology provides an initial application scenario for stablecoins and solves the biggest problem of stablecoins, that is, cold start. Stablecoins such as UST need to be minted by destroying Terra’s token Luna. The larger the issuance scale of stablecoins, the larger the scale of Luna deflation, and the smaller the total supply. On the contrary, when UST is reversely redeemed for Luna, the supply of Luna will increase. .

Thus, Luna’s purpose is to absorb the volatility of UST. For every UST minted, $1 worth of Luna must be burned. Luna maintains the peg of UST to the US dollar through arbitrage and seigniorage mechanisms. If $UST price is > 1$, there is a chance to burn $Luna, mint $UST, and take the difference with the peg as profit. If UST is < 1$, $UST can be burned for $Luna to restore the hook. Buy 1 UST for less than $1 and get $1 worth of Luna. Then sell $Luna for profit. Luna is burning day by day as demand for $UST continues to grow.

What is the source of demand for UST?

Anchor Protocol (hereinafter referred to as Anchor) is a DeFi platform officially launched by Terra in March 2021. It is essentially Lending, similar to Compund. But Ancho’s speciality lies in its extremely high APY (Annual Percentage Yield), which is always maintained at around 20%.

Anchor has three characteristics: simplicity, as long as UST is deposited in Anchor, you can get fixed income and high interest rates; stability, stable interest rates are achieved through the rewards of multiple PoS blockchains; high yield, APY is basically maintained at 20%.

Therefore, in the Terra ecosystem, the lending protocol Anchor, as a “state-owned bank”, promises an ultra-high current yield of 20% to absorb public deposits (in the form of UST).

How much does Anchor need to spend each year in order to maintain revenue? Anchor’s main income includes: loan interest + PoS reward income for loan collateral (currently bLUNA and bETH) + liquidation penalty. Anchor’s main expenses include: deposit interest. Considering that Anchor itself provides high ANC token subsidies for borrowers, and Anchor is in a state of loss as a whole, in order to maintain the ANC token price, Anchor also faces additional ANC token price maintenance costs, that is, to solve the ANC token price selling pressure problem. In other words, Anchor needs to bear about one billion US dollars in expenses every year without considering the liquidation revenue, the maintenance cost of ANC token price, and the salary of team personnel.

Obviously, Anchor alone cannot afford this expense. Just in February of this year, when Anchor’s reserve pool was about to bottom out, Terra’s ecological fund LFG (Luna Foundation Guard) announced that Anchor had allocated 450 million UST to replenish its reserve pool. This confirms one point: Anchor, unlike other lending agreements, is essentially an integral part of Terra’s planned economy. Its current business operations are not for the pursuit of profit, but a fund officially funded by Terra to provide subsidies for the expansion of UST’s scale. The product.

This way we can also see the complete logic of Terra.

First, create DeFi scenarios in the public chain and provide subsidies (represented by Anchor), which shapes the demand for stablecoins;

Demand drives the casting scale of UST, and users begin to be introduced;

Improve the data performance of the ecology, such as TVL, number of addresses, transfer activity and the number of projects participating in the ecology;

The boost in metrics reinforces the appeal of Luna’s narrative;

Based on the improvement of consensus and fundamentals, it is possible to promote cooperation with more leading projects;

Enhanced narrative and consensus, increasing Luna’s transaction breadth (number and region of investors) and transaction depth, and gradually pushing up the price;

The actual controller obtains funds by cashing out or destroying Luna;

Continue to subsidize with cashed-out funds to promote the above cycle.

risk of death spiral

Of course, the above logic is that the actual controller can obtain funds by cashing out or destroying Luna to support the subsidies provided by Anchor. The lower the cost of maintaining the above cycle, the better the access to funding and maintenance subsidies can be.

If the above links can be well realized, the external third-party scenarios of stablecoins will begin to increase, and the acceptance scope will expand; more native Web3 projects and developers will flood into the Terra ecosystem, build more applications spontaneously, and attract more users. In this way, UST is the engine of Luna, and Luna is the stabilizer of UST. When the two interact, when the trend is good, it is easy to form a positive spiral.

Luna is essentially an invisible collateral for stablecoins such as UST. The higher the market value of Luna relative to the stablecoin, the better the transaction depth, the more sufficient the collateral, the smaller the risk of de-anchoring the stablecoin, and the greater the cost of maintaining consensus. low, otherwise it is easy to fall into a death spiral. For example, when the cycle is broken and the price of encrypted assets collapses, the stablecoin and public chain where Terra is located are not immune.

In fact, Anchor is of course aware of the importance of maintaining circulation and subsidy sources, and is also taking steps to increase production reserves. Anchor is adding new collateral assets: bLuna, bETH, wasAVAX, bATOM. It helps increase Anchor’s profits, but doesn’t change much. The next step is to introduce anchor dynamic rates. According to the proposal, the anchored yield will drop at a rate of 1.5% per month, with a minimum APY set at 15%, which will be reached within 3 months.

Since most of UST’s requirements are based on a single protocol, it is crucial for Terra to maintain a high APY in the anchor protocol. If the Anchor Yield Reserve goes to 0 or the APY falls below the point where people want to keep UST on Anchor, demand for UST contracts and LUNA may drop as people will start selling UST, more Luna will be minted, supply will increase the price of Luna Further declines are likely.

In general, with the establishment of LFG and the incorporation of BTC into UST’s reserves and redemptions, Terra Ecology is striving to maintain a business cycle, but under extreme market conditions, can it effectively cope with more and unexpected complex situations? And to prevent the negative spiral, all this still needs to be observed.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/why-is-luna-in-a-death-spiral/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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