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A Terra-ble Turn Of Events

By RAIN EDITORIAL TEAM - May 17, 7:00 PM

This Piece Covers: 

  • Introduction to the collapse of Terra's ecosystem 

  • What is Terra LUNA, and Terra UST?

  • How USTs Peg is Maintained 

  • Incentives Keeping It together

  • Timeline of De-Peg 

  • Crypto Culture

  • Risks 

  • Solutions

Introduction 

The meteoric rise of the Terra ecosystem, coupled with cheerleading by key figures in the crypto community, left little room for vocal skepticism on Terras rise to the top. Negligence and lack of rigorous due diligence by the wider crypto ecosystem has put crypto participants and the broader Bitcoin ecosystem at risk.

The failure of Terra UST's Algorithmically maintained peg has resulted in the liquidation of $3B in BTC; this was almost all of Luna Foundation Guard acquired BTC reserves. With now only $87 Million remaining. This means LFG spent roughly $3 billion to defend the UST peg, without success.

The events of the last week have subsequently led to the collapse of Terra. It's important to consider how this happened, why it was vulnerable to happening and where Terra goes from here?

We steer our focus on LUNA, UST and BTC. 

Standout Data

50 Billion dollars has been erased from LUNA's Market Cap in the last 5 weeks. In that period, the supply of LUNA increased 20x.

Around 25 Billion Luna was minted to bring UST back to peg through the mint-redeem Mechanism. The influx of new LUNA supply to the Market saw its price drop near zero. As a result of the LUNA fiasco, over the last few days, there have been some of the largest daily net inflows ofBitcoin on exchanges in 4.5 years.

Crucial Things To Understand

  • What Is Terra & It’s two token Ecosystem

  • LUNA & USTs burning Mechanism

  • A 'Death Spiral'

  • The Luna Foundation Guard

  • Anchor Protocol

  • Curve Pools 

What is Terra LUNA & Terra UST?

Terra LUNA is a Layer 1, Non-Ethereum Virtual Machine Compatible Smart contract blockchain, able to host various applications. Its underlying blockchain technology leverages that of a Cosmos Software Development Kit (SDK) and has flourished to great heights...Until recently.

The ecosystem has two tokens called LUNA, which is the Governance token and UST, the native stablecoin

What made Terra LUNA & Terra UST Unique?

Terras is a protocol that specializes in issuing stablecoins in-particular its most notable UST.

UST is an Algorithmic stablecoin. There are many types of stablecoin; typically, they are collaterally backed (USDC + USDT) & over-collaterally backed (DAI). There also includes Algorithmic Stablecoins, which are often non-collaterally backed; these are maintained independently by a set Algorithm.

Token design: How does the LUNA & UST Mechanism Work?

In the case of UST, UST functions by burning an equivalent USD-value worth of LUNA to maintain UST's stability by being dependent on arbitrageurs to close any deviations of UST away from 1 USD.

In simpler terms, Terra issues stablecoins under a reversible burning mechanism. So, If you would like to issue a certain amount of stablecoin value, you must burn an equivalent value of Terra's native token LUNA.

So you can always redeem LUNA for UST, dollar-for-dollar, and vice versa. So if the price of LUNA is $80, you can redeem it for 80 UST and alternatively, you can redeem 80 UST for 1 LUNA.

On the other side of this process is that if the price of the stablecoin later deviates ( either exceeds or decreases relative to its peg) so strays array from $1, users can then burn the stablecoin (UST) to then issue an equivalent-value amount of LUNA, pocketing the price difference. This is what is called an Arbitrage Mechanism.

The Arbitrage Mechanism allows you to  always redeem 1 UaST for $1 worth of LUNA even if UST is worth less than $1 USD. This Mechanism was meant to act as a stabilizer. So, for example, If UST is trading at $0.99, arbitrageurs ( via the Mechanism) can buy it and redeem it for $1 of LUNA, pocketing the difference. 

So by nature of this Arbitrage Mechanism, UST's peg is designed to automatically adjust itself through the collective self-interested action of the Market; this can mean you, me, and anyone else interested in the protocol were able to participate in this process if the opportunity arose. 

A Death Spiral 

As mentioned earlier in this article, the market sentiment coupled with the Arbitrage Mechanism for maintaining UST and its peg is highly vulnerable to the exchange rate between LUNA token and currencies on the other end of the stablecoin peg.

Bear market conditions (intense selling)  can lead to a Death Spiral. If confidence has dropped and people are selling for USD or other assets, there is significant pressure on both coins. A Death Spiral, in this case, is the continued relentless selling pressure due to a lack of confidence in the Market, and as a result, leads to an extreme amount of continuous selling on the Market

Confidence in LUNA & UST

When LUNA, the token backing the pegged token (UST), does not have the Market's confidence, this leads the participants to begin dumping both UST & LUNA. Once the spiral starts, it is very expensive and difficult to restore confidence to the Market, leading to an eventual collapse. So, the prevention of the Death Spiral depends ultimately on upholding confidence in the ecosystem.

We saw that the LUNA token supply on the Market increased rapidly, further fuelling its negative price movement, which ignited a negative spiral of downwards pressure on the price. 

Types of Death Spiral Of Luna

Below are 2 visualizations created by one of Luna's Strongest supporters in March, 6-7 weeks before this crash. They illustrate Death Spiral. 

Source: José Maria Macedo, @ZeMariaMacedo

Luna happened to experience the two of these Scenarios.  

Understanding the Incentives: The Role of Anchor Protocol to Terras Ecosystem

Stablecoins often require utility ( that derives their value ) to maintain demand and defend their peg. So, where does UST get its 'utility'? Anchor Protocol.

Anchor Protocol is a savings, lending and borrowing protocol built on the Terra platform that allows users to earn yields on UST deposits and take out loans against their holdings. A huge incentive here is that at the time, it was possible to earn 19.5% - 20% to stake your UST; these yields provided a significant incentive. 

This is significant because there was actually a huge proportion of the UST circulating supply in the Anchor Protocol; representing 35-40%, but it's been as high as 70%. This benefited LUNA deeply, as a large portion of UST was temporarily out of circulation, meaning less circulating supply and more upwards pressure on price. Users who wanted to capture the Yield would need to mint UST by burning LUNA thus putting upwards pressure on LUNA demand and contributing to the value or a "utility" for LUNA.

Questioning the sustainability of Incentives, Value & Utility

If these Tokenomics seem too good to be true, you're not alone. It's important to note that, in regards to what has been mentioned, there is an assumption that Luna has value; this assumption of value enables this redemption between the two coins to take place.

However, value is, or even was derived from demand for Anchor's 20% Yield. Which arguably grew to be unsustainable... This was indicated by looking at the deposits relative to the Yield. It's common across all markets that if deposits go up (demand), Yield tends to go down (due to convexity). In Anchor's case the 20% yield remained the same. To keep Yield the same meant the protocol was becoming unprofitable. 

How were yields being paid? 

Anchor's protocol reserves have been falling rapidly ( below shows the last 30 days); yield paid > money in the Reserve. Anchor was becoming less and less profitable as deposits skyrocketed; this led to some critics questioning how this was sustainable. 

Yield was being subsidized by depositors' Yield from the Reserve, but as demand fell in Crypto, the Anchor rate of 20% could not keep up with the borrowing interest being paid. 

People lost confidence ( along with other factors ) in the sustainability of the Yield and thus led to a mass exodus from Anchor. A fully depleted yield reserve has contributed to investors speculating about this high APY paid out ( Now changed to 4%). This has contributed to causing large volumes of liquidity to exit the ecosystem. 

Source: Mirror Tracker

An increasing yield reserve indicates that the return on collateral staked by borrowers in Anchor is greater than the Yield paid to depositors. A decreasing yield reserve means the Yield paid to depositors is outpacing the staking returns of the borrower's collateral.

Thinking value: Comparing with other stablecoins

Other stablecoins like USDT & USDC are tokens backed by fiat or bonds which provide a guaranteed redemption of equivalent value. UST does not; as an algorithmic stablecoin it uses the LUNA to derive its value. 

The creation of the LFG

As a solution to try and prevent this type of event from happening, Terraform Labs - Terras foundation teamed up with a set of industry backers, to create a reserve fund made up of Bitcoin. This led to the formation of the LUNA Foundation Guard (LFG).

What should have raised more concern is that Bitcoin is still a volatile asset, meaning this should have been challenged more as an asset users as collateral. It has been mentioned that It was used on the assumption that it would be less volatile than other assets in case of a down-turn and that it was more decentralized than using a stablecoin as collateral.

The idea of LFG was to use the BTC to Mitigate the Impacts of a Death Spiral: 

Source: José Maria Macedo, @ZeMariaMacedo

This issue came when none of the above measures could be put into place. The model did not account for the amount of stress the system could take and sadly did not successfully mitigate anything. 

The Curve pools

What's the relevance of the Curve Pool?

An indication of confidence, this is because Curve is the largest DEX specifically to swap stablecoins, DeFi players of all sizes use it to swap in and out of their stable coin tokens. In DeFi it is a favorable option as it's a DEX that optimizes for trades between like-assets such as stablecoins, and so can be used-to assess peg stability. The deeper the liquidity, and the more balanced a pool, the less likely a stablecoin is to de-peg. This means that if there are drastic flow movements to either, it can significantly impact the confidence of a stablecoin. 

Initial Signs of Events Unfolding 

  • Deficits in Curve Pools

  • First De-Peg

  • LFG BTC wallet depleting to keep the peg 

  • Large Selling on Exchanges 

  • UST outflows from Anchor Protocol

Timeline of De-peg: 

Quick break down

May 7th & 9th 

  • The Market started to shake when there was action in the Curve pools. 

  • USTw and 3CRV —- The pool is intended to have a 50:50 ratio of USTw +3CRV or (USDC, USDT, and — represented the largest source of on-chain, non-Terra native liquidity for the stablecoin. - was hit by a large trade. Which resulted in shaking confidence in the pool's liquidity providers,

  • UST as a result on Exchanges was impacted. After this influx $250 million of 3CRV into the Curve pool, reaching as high as 54.2% UST and 45.8% CRV. It then destabilized again.

  • LFG announced that they would be deploying $1.5 billion of its reserves

  • Despite all this Anchor starts seeing major outflows

May 9th

  • On chain liquidity drained, thin order books for UST

  • USTw-3CRV pool ratio ending the day at 95:5, No buy orders on Exchanges

  • Even more outflow of Anchor.

May 10th 

  • The Hyperinflationary Death Spiral

Cultural Element of Crypto 

It's important to do your own due diligence and be aware of the industry figureheads in the crypto space. It can sometimes be necessary to have a couple of second opinions on matters that might seem initially complex. It's important to be aware of who of these supporters are heavily invested in projects. 

It's disheartening that more wasn't done to access the dynamics of UST as an Algorithmic stable coin. These types of stablecoin are the most experimental, and are often supported due to the demand for stablecoins that are not centrealsied by nature. 

Initially, it can be said that there has been a frequent glorification of "Ponzi Economics'', and at times is endemic to crypto culture. Often the crowd has  preference in hyping the growth incentives that are as fast as possible, and avoiding more organic incentives structures, which perhaps are more sustainable. 

Risks

Some may argue that spreading this type of information on the risks is like spreading "FUD" and is unethical because it could cause people to lose confidence in the Terra ecosystem. However, Crypto markets are thin, so one event like this has a catastrophic impact, not for just these two coins but the broader Market in general.

It's the duty of those of use who look long term and want our industry to grow to help avoid/prevent these kinds of short-sighted experiments. 

Direct risk to Luna

  • Security of the Terra blockchain 

  • Recently a direct risk is that the Terra blockchain is at risk, it needed to be halted to prevent a 67% attack. In a situation that could see validators collude to steal assets from the network.

  • Terra Ecosystem

  • This crash has essentially transferred the risk onto the developers of projects building on Terra, and the ecosystem has nearly 100 projects developing on it in the past few months. It has become a dynamic crypto protocol in the industry, with hundreds of passionate teams building some defining applications. Now, in light of recent events, it asks what they will do now? If trust is gone with the terra ecosystem, it may not be past the point of no return, and instead, teams will now be looking to other Layer 1s or layer 2s to build on.

Risk to spread other stablecoins

  • Although unlikely, as a result of the UST collapse, there may be continued panic coupled with the stress-testing on the feasibility of not just Algorithmic stablecoins but also collateral based stablecoins like USDT. For example, fears have abated with reports of billions USD in redemptions being processed normally through tether window. A slight deviation from the peg was also something to keep note of.

Solutions

  • Replace with a collateralized mechanism. This would mean UST would no longer be an Algorithmic Stable coin. It would essentially be backed by collateral.

  • Revival plan 2 , which would create a Rork Terra of Luna to another blockchain 

  • There was a proposal on the official Terra forum The goal is to make people whole again, using Terra's $1,5B funds. However, this fund is not assumed to be closer to $87m

Conclusive remarks 

The Terra situation is still ongoing; there are proposals for what might happen moving forward but these are not yet confirmed. We know that Algorithmic stablecoins are still a work in progress and, for now, are still more of an experiment than a proven and tested stablecoin design. It's important to stay wary of projects that drive user demand using 'Ponzi' incentives. These can prove to be non-robust long, term sustainable solutions. It is also essential to be careful of thought leaders who push projects and who might have a huge vested interest in particular projects. What is positive to note is how well BTC held its own during this massive sell-off. The breakdown above is meant to help guide the reader on what happened in one of the most challenging events to hit Crypto.

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