Changpeng Zhao: 7 conclusions and 3 suggestions on the UST/LUNA crash

Binance CEO Changpeng Zhao published an article on the official blog to elaborate on the lessons learned from the UST/LUNA crash. The full text is as follows:

The UST/LUNA debacle has been bothering me for the past week.

In fact, I talk about this more or less in every interview I participate in. To further clarify my thoughts on this topic, I would like to summarize it here, including personal views, lessons learned, spillover effects, systemic risks, market resilience, regulatory laws, etc.

The UST/LUNA debacle was indeed a regrettable event that affected many people. At Binance, our top priority is to protect every user affected. Sadly, it is difficult to find a solution that pleases everyone, and although the community discussed many proposals, unfortunately, each proposal has shortcomings. I have publicly expressed my views on this matter on Twitter, and Binance has voluntarily allowed the Terra project team to prioritize helping retail investors.

1. Design flaws

First, let's look at the design flaws of UST/LUNA.

Theoretically, when using different assets as collateral to peg to one asset, there is always the possibility of undercollateralization or unpegging. Even if it is overcollateralized 10 times, the collateralized asset may have a 10x higher risk of collapse. Nothing in this world is 100% stable (relative to other things).

● The biggest design flaw of UST/LUNA is that it believes that minting more assets will increase its total value (market value). Printing money does not create value, but only dilutes the value of the tokens in the hands of holders. Minting LUNA at an exponential rate makes the problem worse, so the people who designed UST/LUNA should figure this out first.

● Another design flaw of UST/LUNA is that it provides overly aggressive incentives. Specifically, the 20% fixed annualized rate of return provided by Anchor Protocol has driven too much "inorganic growth". We should not only see the superficial vanity, but pay more attention to the fundamentals. Of course, you can use incentives to attract users to join the ecosystem, but ultimately you need to maintain operations by generating "income", which simply means making more income than expenses. Otherwise, your funds will run out and eventually collapse.

However, in the UST/LUNA model, the concept of "income" is confused, and the project team may use their own token sales or token appreciation as "income", which is obviously flawed. People are attracted to Anchor Protocol because the protocol provides high-yield incentives. Yes, under the stimulation of high returns, LUNA's valuation has been pushed up and attracted many investors to enter the market, but the more people you attract, the more incentives you will give, and you have not created any value yet.

2. High returns do not necessarily mean a healthy project

UST/LUNA was built on a self-perpetuating shallow concept, and while Terra did have an ecosystem with some use cases, the growth rate of that ecosystem did not match the growth rate of the incentives used to attract new users. The growth was "empty" and, eventually, the bubble burst and we were hurt.

Key lesson: Don’t just chase high yields, look at the fundamentals.

3. Trying to restore UST anchor is the wrong approach

The Terra team wanted to use their reserves to restore the UST peg, but were too slow to do so. If they had used their reserves when the decoupling rate reached 5%, the entire crash could have been avoided. But they tried to use $3 billion in reserves to rescue the token after the token value had plummeted by 99% (about $80 billion) - it was undoubtedly too late to save the situation.

You can see that the Terra team looks a bit silly (sorry for the lack of a more polite word) and the lesson learned here is: be highly sensitive in your execution.

On the other hand, the Terra team was also very slow and infrequent in communicating with the community, which further eroded the trust of users in them. So, always communicate frequently with your users, especially in times of crisis.

Finally, I have very mixed feelings about the revitalization plan provided by the Terra team. But as I said, regardless of my personal feelings, we will firmly support the community's decision.

4. Will the UST/Terra incident have spillover effects?

Of course!

In fact, the UST/LUNA crash caused a huge impact on the entire crypto ecosystem. USDT was once decoupled from 0.96, but it recovered quickly. Many crypto projects were also negatively affected in many ways. As expected, most cryptocurrency prices fell, and even Bitcoin price fell by about 20%.

Many people have lost money from high-yield projects, but if you think about it, this may not be a bad thing in the long run. Some shocks in the market will help further consolidate the foundation of the industry and to some extent benefit other more reliable projects, such as BUSD, which has maintained a peg of 1.1 and has maintained capital inflows in the past few weeks.

5. The crypto ecosystem remains resilient

Frankly, I’m very happy with the resilience the crypto industry has shown during the UST/LUNA incident.

The UST/LUNA crash was bigger than Lehman Brothers, but Bitcoin only dropped about 20% from $40,000 to $30,000. Overall, most crypto projects are doing well.

For people who are used to centralized systems, it is difficult to understand the resilience advantages of decentralized systems. In a centralized system, all banks operate in a similar way (regulations require them to do so), they all take reserves from the central bank, and when one bank fails, it has a spillover effect on all other banks. In a decentralized system, all stablecoins work in different ways, there is no common standard or reserve, so even if one stablecoin fails, the impact on other stablecoin projects will not be too great.

Even without the bailout, other major stablecoins in the crypto market have withstood the impact, and most other crypto projects have performed well.

6. In light of this incident, will regulators strengthen their regulatory stance on stablecoins?

I don't know what each regulator will think or do.

So far, from the few people I keep in regular contact with, most of the regulatory responses are optimistic. Of course, the responses I heard may be somewhat biased, because most of the people I keep in close contact with are very friendly to cryptocurrencies. However, I do believe that we need more guidelines on how to regulate stablecoins, such as one regulator said:

“We certainly need to pay more attention to algorithmic stablecoins, but we can’t kill the entire industry because of one failed company, but should keep moving forward.”

7. How to avoid similar systemic risks in the future?

In fact, this is the “trillion dollar” question.

I think there is no absolute answer at this point, because everything has risks, and the fiat currencies you use today have risks. The British pound is the oldest currency in use today, but it has only been around for less than 330 years, and all the currencies before it have disappeared. We can certainly ban or close everything, but that will also stifle innovation. Banks will fail and there will be problems with mismanagement, but we will not close all banks.

Ultimately, we can try to reduce systemic risk. Here are three suggestions:

● As an investor, you need to diversify your investment portfolio and not put all your savings in one basket, even if a project offers high returns.

● It is best to stay away from investment projects with super high returns, because high returns are difficult to sustain and high returns are equivalent to high risks.

● Most importantly, keep upgrading your knowledge and learn about finance every day, such as visiting Binance Academy (sorry, I have to do some promotion here).

The crypto industry is resilient, and while the UST/LUNA crash is regrettable, the crypto industry remains committed to building a sustainable, rich blockchain ecosystem for everyone, and Binance will play a key role in this process.