Lunacy amidst Crypto Crisis
A few weeks ago, a cryptocurrency of over $40 Billion in Market Cap got obliterated. This has caused a domino effect in the global financial markets. Read on to know more.
A couple of weeks ago, a stable coin, UST, lost its peg, causing millions of dollars of losses to its investors. Let’s try to understand what happened.
What’s a Stable Coin?
Stable coins are cryptocurrencies with a constant value of $1. As you can imagine, Stable coins have all the advantages of cryptocurrencies without the extreme volatility of prices.
You can use them to send money to someone or use it for shopping. You can use Stable coins to park conventional crypto when the markets are up and buy more when prices fall without converting to fiat money.
There are two kinds of Stable coins: Collateralized and Algorithmic Stable Coins.
Collateralized coins are backed by cash or cash equivalent reserves. USDC, DAI, and USDT are some examples of Stable coins over collateralized by fiat money.
On the other hand, Algorithmic Stable coins are regulated by an algorithm that keeps the coin’s value as close to $1 as possible. The infamous UST and a new player in the market USDD are examples of algorithmic stable coins.
UST and LUNA
UST was co-created by Terra Labs and founded by Do Kwon. Do Kwon had previously worked with Apple and Microsoft before founding Terra.
Let’s understand how an algorithmic stable coin works. Usually, there are two tokens: One Stable coin and the other Cryptocurrency that backs the stable coin. In this case, the stable coin is UST, and the Cryptocurrency with an algorithmic relationship with UST is LUNA. LUNA’s price is volatile and depends on the market’s demand and supply, among many other factors.
UST is kept stable using what is known as an arbitrage opportunity which happens when the UST loses its peg against the dollar. Consider the scenario where the UST is in high demand and its supply is less. The value of 1 UST will increase to $1.1, for example. The Terra Protocol lets users burn $1 worth of Luna for 1 UST. Essentially, the users are burning $1 to get $1.1 in return, and this arbitrage profit is $0.1. This $0.1 in profit may seem like a small amount, but the users can perform this in large quantities. Users can burn as much Luna as needed. This process increases the UST in the market, and thereby its value decreases and falls back to $1. At this point, users are not incentivized to burn Luna. Simple to understand, right?
Now, let’s consider the scenario where the supply of UST has increased, and its value is now $0.9. The Terra Protocol provides the arbitrage opportunity where users can now buy 1 UST for $0.9 and then trade 1 UST for $1 worth of LUNA. This will burn 1UST and mint $1 worth of Luna, giving the user a profit of 0.1 UST. The Terra Protocol will allow this to happen until UST tokens are burnt, and Luna tokens are minted till the price of UST reaches back to $1.
As you can see, the value of UST is maintained at $1 by this delicate balance. The Terra Foundation had a goal to accumulate $10 Billion worth of Bitcoin as collateral as a long-term goal.
How did it all go wrong?
On May 7th, the UST lost its peg as large withdrawals happened from the Anchor Protocol. Anchor Protocol had allowed users to stake UST for a massive fixed return of 20%. These users in the Anchor Protocol suddenly withdrew UST.
We can only speculate whether it was a coordinated attack. Still, this mass withdrawal of UST led to a fall in the value of UST. As explained earlier, the Terra Protocol will then burn UST and mint LUNA to keep the price of UST at $1. However, the rate at which UST fell was too much for the Terra Protocol to keep up. It just could not outrun the market speed. Also, this mass printing of LUNA led to a price crash of the LUNA token itself, falling 97% in value to just $0.88.
One reason for this fall could be that the UST grew too fast. It took just eight months for the Market Cap to reach $40 Billion from $4 Billion. Another reason was that the Anchor Protocol promised a fixed 20% return. This fixed high return was highly lucrative for many people, and money poured into the Anchor Protocol. The returns of 20% were not market-driven but fixed. Another considerable gap was that there was no lock-in period. Users could withdraw UST whenever they wanted, leaving the Terra Protocol vulnerable to a coordinated attack.
Impact
Reddit is full of users who lost thousands of dollars when the UST collapsed.
There have been many posts where users have lost hundreds of thousands of dollars of life savings and are considering suicide. A Reddit user has said, “I lost over $450,000. I cannot pay the bank”; another Reddit user said, “I will lose my home soon. I’ll become homeless.”
The confidence in Cryptocurrency has taken a massive hit. If a Billion Dollar token can fall, what’s next?
Terra Labs have been at work, and LUNA is returning with LUNA 2.0. Investors may not have the same confidence in UST as before. We will have to wait and watch the fate of the new LUNA.
As always, do your research before investing in any tokens.
Reference — https://www.coindesk.com/learn/algorithmic-stablecoins-what-they-are-and-how-they-can-go-terribly-wrong/
