Oh my "Stablecoin"

Thinking about the Luna crash & what caused it...

Hi All,

First of all, I hope you’re alright? The Luna induced sell-off has been quite something and I can only imagine the devastation people face. If you want to talk I am available on Twitter and my DMS is open.

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By now I am sure that you have seen the Luna/TerraUSD (‘Terra’) crash. Naturally, I was curious and wanted to make sense of the madness. Here, I will (i) explain what Luna and Terra are, (ii) what an “algorithmic” stablecoin is, (iii) the fatal flaw in the tokenomics and finally (iv) the life cycle of this crash. Strap in…

As of writing, Terra is yet to return to peg (@ $0.8) and Luna is well…

Introduction:

Terra is an “algorithmic” stablecoin and Luna is the token used to keep Terra at $1.

What’s a stablecoin?

A stablecoin is a cryptocurrency with a value that is meant to stay at $1. While this is not always consistent across the stable coins, this is effectively usually the case. “Backed” stablecoins are tokens where the underlying value of the coin deviates from something else. For instance, if I kept $1,000,000 in my bank account and promised you that $JOE is good for $1. There are many ways that these backed coins work but let’s leave that for now.

What’s an algorithmic stablecoin?

This is a token whereby due to tokenomics/a smart contract, the arbitrators are encouraged to or the coin automatically returns to peg (returns to $1).

So here’s how Terra works…

TLDR; an algorithm that allows people to exchange Terra for Luna. As long as Luna has a price >$0 (hmm…), the peg can be restored.

Step 1: Luna trades >$0. Let’s say it’s $100.

Step 2: The smart contract (read as “algorithm”) enables people to always exchange 1 Terra for $1 worth of Luna. So if Luna is at $100, one Terra gives you 0.01 Luna. y = 1/x. Similarly, people can get 1 Terra for 0.01 Luna.

Step 3: If Terra trades above $1, arbitrageurs would buy $1 worth of Luna (0.01 Luna in our case) for one Terra worth more than a dollar. They then sell and lock in an instant profit. Similarly, if Terra trades below $1, people would buy one Terra for less than a dollar, swap it for $1 worth of Luna and again instantly profit. This is an incentives-based algorithm that critically, counts on human actors.

Above $1 Terra, people sell down Terra. Below $1, people buy up Terra.

Note: No matter the price of Luna, Terra should tend towards $1.

Side note: Anchor

Anchor Protocol is a platform on the Luna ecosystem that “guarantees 19.5%” yield on USDT stable coin staking. Its performance has not been pretty either. This one was particularly scary as you have large institutions and retail alike, “locking-in” “no-brainer” yield farming. Even start-ups held their reserves this way. This is what makes the de-pegging so awful for me. People lose on capital they wanted to preserve.

NB: Anchor is funded using transaction fees from the aforementioned algorithm.

Death Spiral

Well, we now understand the algorithm.. what could go wrong?!

Let’s speculate. Imagine this, the price of Luna begins to crash. Or even more, people lose faith in the ecosystem. So you have people selling both Terra and Luna.

Step 1: At $0.99 Terra, arbitrageurs will buy Terra to swap out for Luna.

Step 2: They then sell Luna. This causes down pressure on the Luna price

Step 3: People sell more Terra. $0.98. Arbitrageurs will buy Terra again to swap out for Luna. Sending the Luna price even more

Step 4: But people are also selling Luna in the meantime. This causes arbitrageurs' gains to shrink as Luna is falling too quickly for them to capitalise on

Step 5: Terra de-pegs further and further pulling the price of Luna to zero with it.

Yikes.

Eventually, Luna trades at $0.000001 and you can exchange that for 1,000,000 Luna. Well, that’s the end.

The Crash

Days ago significant selling pressure causes the price of Terra to de-peg lower than $1. However, the algorithm described above either (i) could not react or burn/mint tokens fast enough or (ii) there just were not enough people wanting to close out the difference.

To try to fix this, the team behind Luna, the Luna Foundation Guard (LFG), had been buying $1bn+ of BTC to also back Terra. News broke that they were trying to sell out of this as the LFG emptied the treasury wallet of all of the BTC. Their plan was likely to sell BTC and use the proceeds to aggressively market buyback Terra. You can see this attempt in Terra trying to return to peg.

Once this news broke, people tried to front run the sale of bitcoin, selling what they own. Naturally, this sends the price of BTC falling and has a contagion effect on other coins sending them down too. Crtically this included Luna and hence speeding up the decline Terra.

Bonus:

At c.$25, rumours were circulating that the Luna Foundation Guard was attempting to raise $1bn from the likes of Jane Street. This would've been a sale of treasury Luna tokens at a 50% discount locked up for 1 year and a monthly vesting schedule.

This is a super easy trade as you can take on the 50% discounted tokens while shorting Luna on spot. Any Luna price between -50% and the short price leaves you in profit.

In the end, the price of Luna crashed before such a deal could end.

Thank you for reading, God bless.

Joseph

May 2022