We’ve all heard that stablecoins are only valuable to users if their price remains stable. The Terra ecosystem’s $18 billion stablecoin, UST, is pegged to the USD price. Terra’s foundational stability was shaken as its algorithmic stablecoin could not maintain its USD peg; dropping to 30 cents.
LUNA is TerraUSD’s (UST) native staking token and the volatility absorber. LUNA has lost more than half its value since a stunning rally that took it from under $50 to $120 in two months. It now trades for around $4. It represents about 85% of the free fall of the Luna token.
The recent “Fear, Uncertainty, and Doubt” attack on TerraUSD (UST) has caused a downward trend.
How Does the Terra Ecosystem Work?
Terra’s algorithmic stablecoins rely on a two-token seigniorage model. That is to say, Terra holds a collateral reserve in the form of LUNA tokens because the UST is pegged to the US dollar.
So, when the UST exceeds $1, the Terra protocol incentivizes users to burn LUNA tokens and mint UST. When the UST falls below $1, the protocol’s incentives are reversed. This strategy facilitates the maintenance of stability and, well, also not losing the peg against the dollar.
Users can always swap LUNA for UST for $1, irrespective of the market price of either token at the time. This is significant because it means that if UST demand increases and the price climbs over $1, LUNA holders can make a risk-free profit by exchanging $1 of LUNA for one UST token.
Where does the profit come from? As more individuals buy UST, the price of Luna will rise. When consumers begin to withdraw their funds from the Terra ecosystem, the price of Luna will drop, taking the value from those who own Luna tokens.
How did Luna Token Plunge & Why did UST Lose its Peg?
After the UST plunged below 99 cents recently, it obliterated even more of the Terra ecosystem falling to 92 cents and by Monday evening it dipped to 60 cents. And while writing about a day later, it has dropped to 40 cents, which is roughly a 70% fluctuation from the peg. This chaos fuelled the fears of a potential “bank run” among investors.
Let us unravel it bit by bit.
After UST lost its dollar peg twice in three days, Terra’s stablecoin, the world’s largest algorithmic stablecoin, and the financial system built around it were put under strain.
It all started with a large $150 million in UST sell-off on Curve Finance and $84 million in UST on Binance before the peg became damaging.
Curve Finance is a decentralized Automated Market Maker (AMM) that allows traders to execute trades using pools of money rather than attempting to link buyers and sellers to swap tokens for a fee. The curve liquidity pool was effectively exhausted in this case.
It sparked a lot of concern on Twitter, and Anchor Protocol saw roughly $2 billion in UST withdrawals. Anchor is analogous to a bank that pays UST holders a 20% annual percentage yield (APY) if they deposit their tokens on the platform. Anchor provides TerraUSD (UST) with its utility.
Withdrawals on Anchor were bad news because it suggests a lot of UST is leaving Anchor protocol, which will hurt the Luna price. The “de-peg” became much worse. Peg straight up to $0.995 after Do Kwon tweeted. On both Binance and Chainlink (Oracle), the UST peg was nearly stabilizing, while the Luna price is at $64.
Massive whales started selling UST short. The shorts appeared to be coordinated, resulting in a liquidation cascade, and UST de-pegged to 88 cents. Because many significant projects relied on the UST price peg, bulls like Kwon were attempting to prop up the market.
It developed into a battle between bears and bulls, with obvious consequences on the market. Approximately 40% of Anchor Protocol’s liquidity, or nearly $8 billion, has been wiped off as of this writing. Anchor and Luna had months of growth removed in just two days.
The crucial point to remember is that, unlike USDC, UST is not backed by real fiat reserves. Luna is destroyed when UST is minted. So, you have great redeeming power. If there is an unstoppable demand for UST and you are the last Luna token holder on the planet, holders should desire to diamond-hand Luna.
The reason for Luna’s recent rise was the minting of UST, which meant that more people were depositing into Anchor. As a result, more Luna was burned, lowering the supply of Luna in circulation. But now the opposite is occurring.
When UST is removed from circulation, like it was on Anchor, Luna’s supply grows, as it has done in the last few days. And it was one factor that led to the big Luna dump.
Terra bought 37,863 Bitcoins worth $1.5 billion recently as a monetary standard, which is one of the key causes of Luna’s rise. Why did they invest in Bitcoin? It was specifically for instances like this. They desired a “reserve currency” that they could deploy to restore the peg to the UST in the event of a “de-peg” emergency. However, Bitcoin prices are not in favor of the token.
The Luna Foundation Guard, which was founded by Terra’s inventor Do Kwon, has said that it will lend $750 million in bitcoin to trading firms in order to keep UST’s price peg, as well as another 750 million UST to buy more bitcoin “when market conditions normalize.”
What does this mean regarding Bitcoin? Investors are concerned that UST’s bitcoin underpinning would cause the cryptocurrency to suffer additional losses.
So, a multibillion-dollar bet that bitcoin can act as a “reserve currency” for the cryptocurrency economy is being tested at the present as UST struggles to maintain its $1 peg.
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