On May 14, 2022, over $40 billion vanished into thin air. Like smoke. You may be thinking this happened due to some sort of fire or robbery, and while I understand why you'll think that, the real answer is much, much more interesting. There are few moments in history where the facts are stranger than fiction. The story of how Luna 1.0 descended from a valuation of $89 per token to less than a thousand of a cent for the same token in less than a week is one of those few wild events (a black swan, if you will) that can't be fathomed ever happening until it does. And it did. The collapse of LUNA 1.0 will no doubt come to be regarded as one of the landmark events that shaped crypto. Already in its aftermath, there have been calls for tighter worldwide, and a has already been passed into law in the United States. regulations on the cryptocurrency industry stablecoin trust act With the furor generated over LUNA's collapse, a detail that has probably skipped a good number of cryptocurrency enthusiasts is that the fall of LUNA had nothing to do with a security breach or any such cyber mischief. The blockchain platform did not fail, nor was the protocol hacked. LUNA quite simply, fell because it failed to answer one nagging question ponzi-nomic crypto projects cannot satisfactorily answer: where is the money coming from? LUNA's collapse had nothing to do with technical difficulties.  In fact, if anything, the token lost value BECAUSE the protocol worked the way it was designed to. To understand what I mean by this, let us look at the Terra blockchain itself and how it’s designed to work. HIGH YIELD UNSTABLE STABLECOINS Despite how things have turned, it must be said that unlike other with questionable founders, LUNA and the founders of the Terra Blockchain did not set out with the intention of defrauding investors. Terra's use-case was, is, and still remains unique. Here is what the platform offers. sketchy tokens Cryptocurrency has many things going for it, but stability is not one of these features. And everyone knows this. In fact, calling crypto volatile is as redundant as calling the sky blue. While everyone agrees crypto is volatile, the question Terra asked was……what if it wasn’t? What if cryptocurrencies can be stabilized while retaining their fundamental feature of anonymity and free-market trading? What if it were possible to regulate the price of cryptocurrency WITHOUT regulators? This was basically the main idea behind Terra, the open-source blockchain payment platform behind LUNA and UST. Terra is a payment system that resides and is built upon an open-source blockchain. It was developed by South Korea-based Terraform Labs, which was founded in 2018 by Do Kwon and Daniel Shin. At its core, the Terra Protocol looked to solve the issue of volatility by designing a cryptocurrency with an elastic monetary policy that would maintain a stable price while retaining all the censorship resistance of Bitcoin and be viable for use in everyday transactions. What this basically means is this, with Terra you can finally have a stablecoin that does not rely on the dollar or any sort of fiat. It is easy to see how Terra attracted so many fans and lovers of the project in the crypto space. After all, trust in any centralized institution goes against the ethos of cryptocurrencies, and algorithmic stablecoins (in principle) are one of the few ways of attaining both decentralization and price stability at the same time. The beauty behind the idea of the Terra protocol was how it balanced its governance token (LUNA) with its algorithmic stablecoins like UST. Unfortunately, this simplicity would later prove to be fatal to LUNA but let’s take a closer look at just how it works. Creating or minting UST is done by burning LUNA. By burning, we don’t mean actually setting the token on fire, rather, sending it to an address the coins can never be recovered from, essentially sending it out of circulation. Think of burning a token like those letters you sent to Hogwarts when you were a kid. Burning LUNA increases its value because by burning the token, you are reducing the supply of the coin. The goal of this deflationary protocol was to assure the continued expansion of LUNA throughout the long term. The beauty of this idea was how failure-proof it seemed. As long as there is some bid for LUNA, i.e., it has a non-zero price, 1 UST should always be redeemable for $1. Clearly. And perhaps this principle would have held for a very long time, and Terra would have kept its head above water if they did not UST's (SINKING) ANCHOR PROTOCOL As we earlier said, UST is an algorithmic stablecoin. This means it is pretty much backed by nothing. Why would anyone want to hold an algorithmic stablecoin when doing so plainly carries more risk than holding a stablecoin that is backed by genuine US dollars? Well, for some,  the capacity to hold value in dollars without the need for a central authority to gatekeep the system was enough. But others needed to be incentivized. They needed a more profitable reason to commit to a stable coin that was nothing like its predecessors. Terra developers decided that the adoption rate of the stablecoin would grow if it possessed a unique utility that was not possessed by other cryptocurrencies. And this special feature was the Anchor protocol. Terra's long-term objective was to create a vibrant ecosystem of financial apps that were integrated with real-world payment systems. To speed up the process of UST adoption in the short term, the idea of offering a very profitable yield was decided as the best route to go. An impossibly high yield too. Enter Anchor,  a protocol that offered an interest rate of 20% on UST. The proposition is that rather than keeping your savings in a bank account, where they will receive an annual interest rate of 0.06%, you can invest it in UST, where it can earn an annual interest rate of over 20%. Passive income on a golden plate. Who could resist such a proposition? Because of Anchor, the rise in the demand for UST skyrocketed as customers hurried to take advantage of the greater yields. At its height, the circulating quantity of UST was over $18 billion, while the total value locked in by Anchor was more than $15 billion (TVL). THE UST DE-PEGGING The two key pieces of information you need to understand what happened are this : Humans are herd animals who scatter at the slightest show of panic. Just really basic arbitrage knowledge Earlier I mentioned one way to get UST is by burning LUNA. While this is true, it’s not the only way. The second available option for UST is to use the stablecoin exchange known as Curve Finance. Usually, when a stablecoin is subject to a tiny price adjustment, astute arbitragers will travel over to DeFi's deepest liquidity pools on Curve and trade the discounted stablecoin to whichever alternative currency has maintained its peg. For instance, if DAI is now selling at $0.99, investors will purchase DAI at a discount and then resell it for USDC (which, for the purposes of this example, is $1) in order to make a profit. This buying pressure typically causes the price of DAI to rise to $1 from its previous level and reclaim its peg. To use more practical terms, think of it as buying the Mona Lisa from the Louvre on a special black Friday sell-off and selling it back to the French museum the next day after the discounted sales are over. You’ve not only made a profit, but you also did so without spending an extra dime. But that sale would only be profitable if the store goes back to its original price valuation of the MONA LISA before the black Friday discount sale. Sadly, in the case of UST, it didn’t. Why? To answer this, we would have to reexamine UST’s infamous Anchor Protocol. Try as the Terra devs might, it was quite obvious that a 20% interest yield was pretty unsustainable. And the cracks were starting to show. After being advertised as "stable" when it was initially set at 20 percent, the rate had gradually been going down ever since March, was finally approved. According to the proposal, the interest rate would go up by 5%  if Anchor's reserves went up by 5%. If these reserves were to drop by 5%, the interest rate would drop by 2% as a direct consequence. when Proposal 20 In addition, it was anticipated that this rate would continue to fall by a continuous 1.5 percentage points every single month if there were more lenders on the platform than borrowers. Because it was anticipated that interest rates would go down, the UST's primary use case started to become pretty much less important. For example, on April 23, more than 72 percent of all UST that was in circulation was secured in Anchor. At this point, it was quite clear that the stablecoin was almost entirely used by investors whose sole intention was to deposit funds in Anchor. When it became apparent that the interest rate of 20% was not going to be maintained, investors of USTs started selling their holdings. This move triggered a sell-off that would have been pretty mild and absorbable but for one large black malicious swan. Over the course of the weekend, Anchor users who were leaving the exchange began trading their UST for other stablecoins, such as Tether's USDT or Circle's USDC. This caused the price of UST to depeg by a little less than $0.02 USD. Eventually, the particular pool that enabled these trades, which is known as the "UST + 3Crv" pool and also pools all of the major stablecoins, became unbalanced. This meant that there was a significantly greater amount of UST than there was of any of the other stablecoins in the pool. Let's take a moment to pause and discuss what takes place when you sell UST in exchange for USDC on Curve. If you sell UST in exchange for USDC on Curve, more UST will be added to this pool, while USDC will be removed. At some point in the future, the pool will include more UST than USDC. The pool then begins to offer that UST at a discount in the hopes of luring arbitragers into making the opposite trade in an effort to rectify its path (and rebalance the pool). This is one of the reasons why we started to observe a tiny depegging at the beginning of the weekend; Curve was simply doing what it has always done since the day it was invented. The fact that the trade that would have restored equilibrium to the pool was not carried out was the source of the issue in this particular scenario. It seemed as though nobody wanted to be in possession of UST, despite the fact that arbitrage trading may be rather profitable. As for the reason why, well, don't forget that Terra's most popular app, Anchor, had already started to lose its popularity. Basically, no one was convinced enough to buy UST anymore, even when such a trade SHOULD have been profitable. And it was this environment of mistrust that enabled the depegging. Many conspiracy theorists pin the actual depegging event on bad faith whales. At least poured more than 85 million UST tokens into this pool in return for 84.5 million USDC tokens. This put even more pressure on the dollar peg that UST was using, and Curve continued to create the discount in the hopes that it would encourage arbitrage traders to rebalance the pool. They didn’t. And down the LUNA peg went. one investor On Sunday, 7th May, the depeg was only $0.02, but by Tuesday the 9th, it had ballooned to an astounding $0.32. At the same moment, the LUNA token that was worth $64 dropped below $30. Now here was where it got dicey. As you recall, the LUNA/UST ratio was $1 to $1. That is, as long as LUNA traded above $1 , you could burn it for UST. Unfortunately, around that same time, the market capitalization of UST began to inch closer to surpassing that of LUNA. This would mean that LUNA would no longer be able to absorb the market capitalization of UST. This caused the infamous death spiral. According to the Terra protocol, exchanging UST for LUNA will result in the creation of additional LUNA, which will dilute the supply and bring the price of this token down. In addition, the price of LUNA was falling, which implied that in order to trade 1 UST for $1 worth of LUNA, you will need a continually increasing number of LUNA until you reach the $1 level (which meant minting even more LUNA). Clearly, this was a critical time for the Terra community. A time they needed to hold it together and soldier on. They didn’t. The pack broke. And people began to run for the Exit. But it was too late. LUNA was gone. CONCLUSION The crypto industry is a uniquely new and ever-innovative field. Each day always brings something new to the sector. Despite this, crypto, like any other investment asset is subject to the laws of finance, and the simple law of common sense which states, if anything looks too good to be true, it probably is While crypto can be wildly rewarding, success rarely comes in investment plays that ONLY promise profit, especially when it also comes with the caveat of you doing little to no work and the project's continued success depends on a steady influx of new buyers. There is no such thing as a free lunch. Whether the project is disguised as an exotic Move-to-Earn protocol or a "sensible'' saving and staking protocol, all unreasonably high yield ''passive income'' crypto projects all fail this simple test : Where does the money come from? If 98% of profits is coming from new buyers or new or compounded investments, you have your answer. If you're investing in a crypto project with a source of earning suspiciously similar to this, make sure to get in early and get out early. Or do not get in at all. Many LUNAtics sure wish they did.

Tether

USD Coin

Terra

2022 - HackerNoon Contributor of the Year - Finance

2022 - HackerNoon Contributor of the Year - Future Of Finance

2022 - HackerNoon Contributor of the Year - Investing

Nominated for 2022 - HackerNoon Contributor of the Year - Investing

Nominated for 2022 - HackerNoon Contributor of the Year - Future Of Finance

Nominated for 2022 - HackerNoon Contributor of the Year - Finance

Too Long; Didn't Read

In your car, at home, or at work — Bosch technology shapes many areas of life.

PONZI-FI: Why Passive Income in Crypto is a SCAM

PONZI-FI: Why Passive Income in Crypto is a SCAM

Too Long; Didn't Read

People Mentioned

Company Mentioned

Coins Mentioned

Ogunwale Emmanuel

Share Your Thoughts

About Author

TOPICS

Languages

THIS ARTICLE WAS FEATURED IN...

PONZI-FI: Why Passive Income in Crypto is a SCAM

Too Long; Didn't Read

People Mentioned

Company Mentioned

Coins Mentioned

Ogunwale Emmanuel

Share Your Thoughts

About Author

TOPICS

Languages

THIS ARTICLE WAS FEATURED IN...

RELATED STORIES