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Terra Luna's Crash (Banner)

Terra Luna´s Crash

BenjaminMeyer
Linkedind

Ben - 23 May 2022 - 8 min read

Welcome to Terra Luna’s crash and the fastest meltdown of a top cryptocurrency

Now that we understand better what hyperinflation means, let’s have a deep dive into the fastest hyperinflation to date: Terra’s Crash.

Terra’s ecosystem is run by two cryptocurrencies: Terra (LUNA) and UST (also known as Terra USD). While Terra (LUNA)’s value is determined by demand and supply, UST is a stablecoin.

Stablecoins are cryptocurrencies with a relatively stable price. This stable price is achieved by tying the price to a commodity (like Gold), currency (like the US Dollar) or by having the supply regulated by an algorithm.

UST is tied to the US Dollar by using an algorithm that balances its supply to keep it as close to 1 US Dollar as possible. We refer to this as the price being pegged to 1 US Dollar which brings us to the ideal equilibrium where 1 UST = 1 USD.

What happened to Luna Terra?

On May 9 the UST lost its peg, which means that 1 UST was no longer equal to 1 USD. The Terra team and some of its partners tried to stabilize it again by deploying $1.5B worth in Bitcoin in order to buy UST and bring up the price again to 1 USD. However, it did not work.

On May 13 the UST reached its all-time low at around 0.04 USD. Despite an increase back to over 0.1 USD since then, UST trades significantly below its intended value of 1 USD.

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Source: CoinGecko

Now let’s turn our focus towards Terra (LUNA) and see what happened to it at the same time. Before the collapse Terra (LUNA)’s price was trading at around 60 USD. During May 10 it then dropped sharply to approximately 30 USD. For a couple of hours, it seemed to stabilize there. Then, it dropped again and below 1 USD in the following 24 hours. Terra (LUNA) reached its all-time low as well on May 13, trading at 0.00000099 USD. Since then, the price increased a bit again, as trading volume came back – probably some short-term traders took their chance – but it is still far below 1 cent. Terra (LUNA) lost $20B in a few days and was trading at a market cap close to zero for a few hours.

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Source: CoinGecko

Why did this happen?

So far, we were stating the visible facts, but you might wonder as well how this could happen?

As mentioned before the Terra ecosystem consists of two supply pools: An UST supply pool and a Terra (LUNA) supply pool. Terra is using something called an “Automated Market Maker”. Simplified it is an algorithm that is supposed to keep UST and Terra (LUNA) in perfect balance.

The algorithm handles two cycles, which can be called “expansion” and “contraction”:

  • The “expansion” cycle:
    • Expansion occurs when there is high demand for UST e.g., because the staking rewards are very attractive. Terra and its ecosystem were offering one of the highest interest rates with 20% APR (annual percentage rate).
    • High demand means, that more market participants want to buy UST. If something becomes scarce these market participants are willing to also pay a higher price. Thus, pushing the price up and above the 1 USD. As a consequence, UST loses its peg to the US Dollar (remember: peg means 1 UST = 1 USD).
    • If the price of UST is above 1 USD, arbitrage gains can be realized. For example, if Terra (LUNA) would be worth 10 USD, it can be sold for 10 UST. These 10 UST can then be sold in the market for USD. If 1 UST = 1.5 USD (see illustration below) the seller would realize 50% arbitrage gains.
    • When Terra (LUNA) is exchanged for UST, Terra (LUNA) is burned and therefore removed from the Terra (LUNA) supply pool. At the same time UST is created (minted), which leads to an increase of the UST supply pool.
    • Increasing UST supply puts pressure on the UST price and eventually brings it back to its peg at 1 USD.

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  • The “contraction” cycle:
    • Contraction occurs when there is less demand for UST. For example, when the staking rewards are not high enough to attract buyers.
    • Sellers are inclined to get rid of their UST at lower prices to the remaining buyers. This pushes the market price down and below 1 USD. Again, the UST loses its peg to the US Dollar.
    • Buyers can now buy UST at a price below 1 USD on the market and buy Terra (LUNA) with UST as if it would still be worth 1 USD. In our example (see illustration below) buyers could get 10 UST for 5 USD and then trade these 10 UST for 1 Terra (LUNA). By doing that they would realize 5 USD or 50% profits.
    • When UST is exchanged for Terra (LUNA), the UST supply pool is reduced, while the Terra (LUNA) supply pool increases.
    • When UST supply becomes scarcer the value and price of 1 UST reacts accordingly and eventually moves up again to 1 USD.

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Terra’s crash happened because something went wrong in the “contraction” cycle. A lot of Terra (LUNA) was minted in a very short time and caused the TERRA (LUNA) price to drop significantly.

The big question is: Why did the “contraction” cycle fail? And why did none of Terra’s efforts lead to a repeg of the UST to be worth 1 US Dollar again?

The fastest digital hyperinflation to date might not have happened for just one reason but a couple of factors playing together. We only want to provide a short overview of the most plausible drivers behind the crash:

  • The “short seller” theory

Shortly before the depeg happened, a few large UST withdrawals took place within the Terra ecosystem. In other words, $2.7B worth in UST were sold in a very short time. This likely triggered the depeg. A similar explanation is currently trending on Twitter. In short, one person sold $350m worth in UST in a single transaction to cause the depeg and make Terra deploy their Bitcoin reserve of $1.5B. This action dragged down the Bitcoin price, while that person sold its short position on Bitcoin and made $800m within hours. We know, this sounds a lot like George Soros bet against the British Pound in 1992.

  • The “design flaw” theory

While the previous has a touch of conspiracy a more rational discussion is that the problem lies in Terra’s design of its stablecoin UST. The “expansion and contraction” mechanism should ensure that the price is rebalanced and stays close to the US Dollar. But unlike many other stablecoins UST was never backed by any commodity or currency – especially not by the US Dollar.

  • The “bank run” theory

When UST lost its peg by a wide margin, a lot of UST holders pulled the trigger and dumped their UST for Terra (LUNA). The measures taken by Terra were not enough to restore the trust. Instead, arbitrageurs took over, realized their arbitrage gains and flooded the Terra (LUNA) supply pool, pushing the Terra (LUNA) price off the cliff.

Do you think Terra (LUNA) will recover? We were asking us the same question.
You will find out in our next article.

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