LUNA-UST’s Collapse: What Happened, 2 Easy Reasons Why

Understand the reason behind LUNA-UST’s Collapse

Unless you’ve completely switched off from crypto, or the news cycle for that matter, you’re probably aware of LUNA losing 99.99% of its value in a matter of days. Terra Protocol and its two main tokens – UST and LUNA – went into freefall as a carefully constructed mechanism (supposedly) hit a snag. And a big one at that.

To understand what happened, it’s important to understand UST and LUNA’s correlation in the Terra ecosystem. UST is a stable coin; however, unlike USDT (Tether) or USDC, it’s not backed by cash, short-term US govt. securities, commercial papers, etc. UST is an algorithmic stable coin – it maintains its peg to the USD through financial engineering. Or at least it used to.

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How Does It Work?

Terra made use of an arbitrage function to maintain UST’s peg. The protocol has two pools – a LUNA pool and a UST pool – and each can be traded with the other. The key: 1 UST can always be traded for $1 worth of LUNA.

Also Read: Luna: Terra’s Legal Team Resign Amid Crash Saga

So, if UST loses its peg and drops to, say, $0.99, traders can trade a large quantity of it for LUNA worth $1 each, thus earning a profit of $0.01 on every token. Traded UST is burned in the process, further reducing the supply and increasing its price to $1.

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Conversely, if UST’s value rises to, say, $1.01, traders can trade LUNA to create UST and earn a profit of $0.01 on every token. UST supply increases and the price drops to $1 again. Also, traded LUNA is burned in the process, making it more valuable.

Furthermore, to incentivize traders to burn LUNA and create UST, Terra offered a whopping 19.5% yield on UST staking through the Anchor Protocol. Prior to the crash, over 70% of UST’s circulating supply was staked in this protocol.

The Luna Foundation Guard (LFG)

To protect the peg further, Terra founder Do Kwon created the LFG, a non-profit that held a reserve fund of around $3 billion in BTC and other cryptocurrencies. Its job was simple – if UST dipped well below $1, the LFG would use the reserves to buy tokens and restore its peg.

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If UST rose, they would sell UST and bring it back to $1, with the profit being used to replenish their reserves.

So, What Cause To LUNA-UST’s Collapse?

The catalyst began on May 7-8 and cascaded into Monday, May 9 – over $2 billion worth of UST was unstaked from the Anchor Protocol and hundreds of millions were sold immediately.

This huge selling volume pushed UST’s price to $0.91. Traders rushed to take advantage, trading $0.9 worth of UST for $1 worth of LUNA. However, there was a hitch – only $100 million worth of UST can be burned for LUNA per day.

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Consequently, UST couldn’t retain its peg, and investors flocked to sell their stock, driving the price further down. This had a knock-on effect on the whole ecosystem and LUNA was dumped into oblivion.

The LFG quickly exhausted its reserves trying to restore UST’s peg but in vain. Over a billion in BTC was sold in the process, triggering a sell-off and affecting the entire market. Billions of dollars in crypto value were wiped out within a matter of days.

This event further highlights the key tenets of investing: do your own research, give weight to fundamental analysis, and only invest money that you can afford to lose.

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RoyalStranger

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