Trial of a Madman: Can UST/LUNA ever go back?

You may have noticed that things have been pretty volatile in the markets lately. The madness is driven by idiosyncratic factors, the bear market has been here for a few months, and much of the madness is caused by the risks of the Terra model.

As the circulating supply of UST grows, it gives LUNA's price an upward momentum. This works very well in a bullish market because as UST's use cases increase, demand increases, allowing users holding LUNA to see their tokens directly create value. However, in a safe-haven market, the same mechanism can create a problematic death loop.

Let’s quickly recap what happened with LUNA and UST, and think about what the Terraform Labs (TFL) team needs to do to ensure that a bank run like this doesn’t happen again.

background

1. People tend to prefer safe-haven assets. Macro conditions have clearly deteriorated for some time, with global unacceptable interest rates and deflation putting continued pressure on stocks and cryptocurrencies. This has led investors to shift from undercollateralized stablecoins (UST) to fully cash/cash equivalent collateralized stablecoins (USDC, USDT).

2. UST’s underlying assets/liabilities are mismatched. Despite being uncollateralized, UST can always be redeemed 1:1 for $1 of LUNA, a fact that creates a direct relationship between token demand. In rising markets, the mismatch is not a problem. However, in down markets, balance sheet concerns become more pronounced and algorithmic risk surges.

what happened?

1. LFG first issued a statement to transfer $150 million of UST liquidity from the 3CRV + UST pool in preparation for the launch of 4pool. At the same time, an anonymous address bridged and sold $85 million of UST.

2. This sale caused the Curve pool to become unbalanced and put downward pressure on the UST price. To help correct this depegging, LFG removed an additional $100 million of UST liquidity from Curve.

3. But this is still not enough to restore UST's anchor, and panic has slowly spread among the crowd.

4. Due to the design of the protocol, the price of LUNA is always linked to the circulation of UST. However, in the context of a large-scale bank run, the price of LUNA falls rapidly, which means that UST is destroyed and exchanged for more and more LUNA, thus creating a potential death spiral and bringing the side effect of blockchain congestion.

5. This congestion led to further increase in people’s panic.

6. Positions in Anchor are mainly secured by LUNA. The decline in LUNA prices has led to the liquidation of UST, which has further put pressure on the price of UST.

7. TFL partners added over $280M of non-UST liquidity to the 3CRV + UST pool in an attempt to stop the bleeding. This liquidity was quickly consumed as outflows were significantly higher than “bailouts”.

8. A large amount of Anchor deposits have been outflowed, and the pressure on the UST market has increased dramatically.

9. These anchored USTs have two destinations: still exchanged for LUNA worth 1 USD, which will lead to stronger selling pressure on LUNA; or transferred out of the Terra chain and sold, exacerbating the decoupling of UST.

10. Less UST leads to more LUNA, and the price of LUNA drops faster

11. LFG then decided to borrow 750 million BTC off-market to help UST restore its peg. After the market normalizes, it will borrow 750 million UST to repurchase BTC.

12. The problem is that UST has become very cheap, so TFL's ability to repay market makers has decreased. If BTC is liquidated and sold, it will further drag down the market and further aggravate the death spiral.

As of afternoon, the peg had recovered from a low of $0.66 to $0.90. Nonetheless, as UST converted to LUNA continued to be sold on the market, the price of LUNA has steadily declined.

The remaining questions

The key point of the Terra bear thesis remains the lack of an exotic yield protocol that interacts with UST. Stablecoins are designed to be highly liquid trading instruments, however, with UST, liquidity is leveraged and highly concentrated on one platform. Anchor had $14 billion in deposits a week ago, while UST had a market cap of $18 billion. Clearly, there are a limited number of real use cases other than earning money on deposits in Anchor.

This makes UST a riskier asset relative to other stablecoins backed by cash or cash equivalents like USDC and USDT. The yield generated by UST is largely through the compression of Anchor's yield, and as investors shift from chasing yield to risk aversion, UST's sole appeal becomes less important. Even before the "4POOL" problem, funds had begun to flow out of "Anchor".

So, what is Terra’s solution?

1. First, the team must once again build confidence in the algorithm and the entire model. Without it, the underlying "algorithm" will not work. Selling pressure on LUNA will only continue until there is enough funding to support the peg. Speaking of which, there is a lot of discussion about fundraising for peg defense, which does help to eliminate the fear of this de-anchoring.

2. Second, and most importantly, is to create use cases for UST outside of Anchor. While this has been an ongoing goal of the Terra ecosystem, it has not yet been achieved. If UST is held through the treasury, used in pools, or truly integrated into DeFi, bank runs will become more difficult.