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Revisiting the crash moment of “LUNA Brothers”

We are witnessing the biggest crash in crypto history, comparable to the Lehman Brothers crash in 2008.

In just 5 days, the price of LUNA fell by nearly 100% until it returned to zero, the algorithmic stablecoin UST on it was completely decoupled, and the market value of up to 41.9 billion US dollars was wiped out. 

Let’s recap how LUNA and UST collapsed.

Overview of LUNA and UST

UST is a completely algorithmically determined stablecoin issued on Luna, which aims to maintain a 1:1 peg to the US dollar through the minting and redemption mechanism of $1 UST=$1 LUNA .

It works as follows

1. To cast UST, users must burn equivalent LUNA. For example, burning $1 of LUNA mints $1 of UST.

2. To withdraw from UST, users can exchange UST for a corresponding amount of LUNA of equivalent value (UST is calculated as 1 USD).

This means that when UST trades above $1, arbitrageurs are incentivized to enter and arbitrage by burning LUNA in exchange for UST, increasing the UST supply and reducing its price. 

When the UST market price is below $1, the same mechanism leads arbitrageurs to redeem LUNA at the UST peg price of $1, using the difference between the UST market price and the peg price to arbitrage to increase the UST price by reducing the UST supply.  

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Until May 7, UST’s algorithmic mechanism was largely successful in maintaining UST’s pegged price.

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From Dune user @SebVenture

A few key insights

1. Unlike stablecoins such as DAI, UST is not backed by any external collateral. Instead, it is secured by the system’s internal asset, LUNA, and the system’s “reserve” is essentially the value and liquidity of LUNA. This means that LUNA absorbs the volatility of the system.

2. Therefore, the survival of UST depends on the market demand of LUNA. LUNA is mainly used to protect the L1 public chain Terra built on the Cosmos SDK.

3. UST relies on the open market for stability, requiring major stakeholders in the Terra ecosystem such as third-party market makers such as Jump Crypto to maintain a price peg.

4. The system is more capital efficient as it does not require over-collateralization (like DAI) or debt demand to increase its circulating supply.

5. The mechanism is vulnerable to a “death spiral”. As mentioned above, if people lose confidence in the peg, UST holders or arbitrageurs will withdraw from the system or arbitrage by redeeming UST to mint LUNA, because more LUNA will be withdrawn with the same value of UST, which will cause the price of LUNA to drop sharply. The cycle of redemption causes LUNA to over-inflate, creating a “bank run” effect, and both LUNA and UST die.

The key time point of the LUNA crash

Initial Panic: May 7th – May 8th 

UST was first threatened with decoupling on May 7, due to the fact that $85 million of UST in the UST-3pool was exchanged for USDC when LFG established the 4pool.

The UST-3pool pool has a 50:50 ratio of UST and 3CRV (USDC, USDT and DAI trading pairs are included on Curve). Although the UST-3pool pool held about 5-6% of the UST supply at the time, it was the largest stable source of on-chain, non-Terra-native liquidity.

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From Dune user @SebVenture

This huge transaction finally shook the confidence of the liquidity providers of the capital pool, who quickly withdrew 3CRV, causing the capital pool ratio to drop to 77%UST and 23%3CRV on May 8.

Binance, the most liquid centralized exchange for stablecoins, saw UST drop to $0.985 on Binance.

All was well at this point. This ratio and the price of UST eventually recovered after $250 million in 3CRV flowed into the pool, reaching 54.2% UST and 45.8% 3CRV, although it immediately started to be volatile again.

Also, on Binance, the UST price has recovered to around $0.995.

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On the evening of May 8, the Luna Foundation (LFG) joined the fray, announcing that they would deploy a $1.5 billion reserve:

1. Lending $750M in BTC to market makers to defend peg to UST

2. After the volatility subsides, borrow another $750 million in UST to repurchase BTC

However, there are signs that confidence in the UST has been permanently shaken. During the period from May 7 to May 8, the outflow of funds in Anchor exceeded 2.86 billion U.S. dollars, and the deposits fell from 14.02 billion U.S. dollars to 11.16 billion U.S. dollars in two days, a decrease of about 20.4%. Meanwhile, the price of LUNA fell from $76 to $63, a drop of about 17.1%.

Second decoupling: May 9

On May 9, the decoupling began again. UST prices on Binance fell to $0.60 in a day, with the exchange at one point preventing traders from placing bids below $0.70.

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The vast majority of UST’s on-chain liquidity is exhausted, and the UST-3pool ratio reaches 95:5. Other Curve pools suffered a similar fate as LPs did their best to escape exiting the market. Anchor’s panic also continued, with another $3.83 billion withdrawn from its currency markets.

Another key sign that further fueled the panic was the overtaking of UST’s market cap over LUNA’s. Before the crisis began on May 7, LUNA had a circulating market capitalization of about $25.2 billion, while the total UST supply was $18.79 billion.

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Although the LUNA “re-flip” UST happened when the LUNA price fell to $51 with a market capitalization of about $17.5 billion. But there is no real impact on the mechanism, which further erodes confidence in the system and fuels panic among market participants.

As redemptions increased, the price of LUNA fell 48% on the day, from $60 to $31, further reinforcing the run by UST holders.

Hyperinflation death spiral: May 10 to May 13

Although UST’s price on Binance was as high as around $0.93 at one point, its fate was almost doomed at this point.

1. UST decoupled violently again, and the exchange traded as low as $0.225.

2. The liquidity on the chain is also completely exhausted, and the proportion of UST in the UST-3 pool reaches 97-98%.

3. Anchor depositors continue to flee massively, with the protocol holding only $2.18 billion in UST deposits, down 84.49% since the crisis began.

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UST Deposit Source in Anchor: Smart Stake

As liquidity disappears, the only way for UST holders to exit the system is through redemption, i.e. minting new LUNA and selling it on the open market. This UST infinite minting LUNA mechanism triggers a death spiral, causing the circulating supply of LUNA to expand dramatically from 386 million on May 10, to 1.58 billion on May 11, to 176 billion on May 12, and to 65,000 on May 13 100 million.

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LUNA additional issuance data comes from terrasco.pe

This kind of additional issuance intensity, even if it is Da Luo Jinxian, the price of LUNA can no longer be saved.

The price of LUNA was around $30 on May 10, fell to $1.1 on May 11, fell below $0.01 on May 12, and fell to around $0.000001 on May 13, down 99.99% for several consecutive days. Binance, OKX and other exchanges have directly delisted LUNA and UST trading pairs. LFG also stopped the operation of the Luna public chain many times.

Based on the market value of $41.93 billion when LUNA was priced at $119 on April 5, the $41.9 billion LUNA/UST brothers collapsed within 5 days.