The crypto market was recently shocked by the collapse of the LUNA token and the UST stablecoin, impacting negatively on the Terra ecosystem in general as of May 7, 2022. After 6 days, the crash operated as a death certificate for this cryptocurrency. It became trending topic for many people, even for crypto market outsiders, and the news impacted on media as well.
We will release three posts for a better understanding of the situation. In first place, we will attempt to explain the situation prior to the crisis (this post), then we will explain what happened in May and what’s next. Our third post will provide some legal aspects on the crash. Considering that our readers have different levels and expertise areas, articles have seen separated in three topics with links, videos and complementary bibliography for further details on the Terra crash.
Some of the questions we will approach in this article are: How did Terra work? Was the collapse foreseeable? How does it affect to those persons holding LUNA and UST, did they lose everything and that’s all? Do they have any value?
For those who prefer videos, we recommend this one from Coin Bureau with clear concepts on the headlines approached here (except the legal approach).
What are/were the contributions of the Terra ecosystem?
The Terra ecosystem, created mainly by Terraform Labs as software developer, funded by big investment rounds raised by private investors with private capital and audited by the Luna Foundation Guard (“LFG”, formed by big risks investors and e-commerce giants), worked as a great opportunity for the decentralization of payment methods and was considered a threat to the nations’ sovereignty in terms of money printing. The ecosystem had been designed to promote a truly decentralized economy fostering the public access to FIAT currencies through tokens pegged to other currencies at a rate of 1:1 (among other usages, including games and NFTs).
This is achieved using “oracles” (software for managing real world data to programming. In this case, coins relative value) and ATOM blockchain validators. This booming way for the purchase, sale and transfer of currencies at their current value instantly represented a revolution in payment processes.
The fees due for financial and payment services were paid in LUNA (the ecosystem native token). LUNA was used for everything: to pay for transfers, to produce yields, to buy assets and to pay for services inside the network; it was also used to vote on the future of the project and to maintain UST price and other stablecoins’ prices as well. The technical process is quite complex involving mint and burn mechanisms and a market free arbitrage system with rewards for maintaining peg stability. As we said at the beginning, this complex mechanism failed and the algorithm process was unable to cope with the situation.
Is LUNA still worth something?
The variety and number of projects developed in the Terra ecosystem aiming to the development of a synthetics market pegged to stocks and FIAT currencies as well as loans and investments protocols, together with an easy access to decentralized assets in an easy and speedy way to anyone having access to internet, remain as a valuable feature for the company. However, the trust in the developers and their systems have disappeared. It is still to be defined whether the confidence can be restored before a new project comes along and “fills the gap”. Anyhow, it is to be expected that someone tries to fill in this need that LUNA and the developers detected.
The software involved in Terra ecosystem and the low price it has shown in mid-May would have made it an interesting acquisition. The last price of LUNA and UST token (before they were renamed as LUNC and USTC) is attributed, on one side, to the great token generation during the collapse and, on the other side, to the total distrust by investors and the crypto ecosystem. In spite of the experience achieved, the LUNA team will not be likely to make alliances with other networks and /or recover the adoption level achieved in 2021 and in the first quarter of 2022.
Algorithmic coins and Peg
The UST (coin causing the collapse) is/was an algorithmic stablecoin pegged to the dollar. Here below you will find the process description in a simply way: it is called “peg” and there is only one precedent prior to this crash for reasons beyond Terra’s control. For further peg information, enter this article from ambito.com (in Spanish).
Peg stability depends on market incentives under reliable market conditions. For example: UST is traded in the market at USD 0.8 per dollar, in Terra blockchain UST is traded at USD 1. That dollar is used to purchase LUNAs which will be subsequently sold to a stablecoin with a profit above 20% without limit in terms of amounts nor transactions. The key question is if UST keeps on being a reliable and trustful stablecoin or investors will switch to another one with the unavoidable damage to Terra ecosystem capitalization (this is indeed what happened). In November 2021 the opposite process happened: UST was largely demanded in several blockchains as an exchangeable stablecoin (therefore increasing LUNA’s price).
Was the collapse foreseeable?
Despite the fact that many people reported suspects on the system and had concerns about the risks involved, this huge collapse was completely unexpected and could only happen when the “security system” (4pool) was inactive. It is obvious that algorithmic coins have an additional risk but the crash exposed some major loopholes in the algorithmic-backed stablecoins with great impact on the entire crypto ecosystem. Other security measures could have avoided the crisis like, for instance, the conditions applicable to bank time deposits in terms of deposits and withdrawals, even though they are contrary to the crypto ecosystem spirit.
Some people outside the crypto ecosystem had major concerns regarding Anchor Protocol, the lending and borrowing platform that paid an interest rate of almost 20% in dollars through smart contracts. The protocol basically boosted micro investors’ yields with deposits of other cryptocurrencies and its governance tokens with a yearly yield between 18% and 20%. This operation was supported by the UST flow generated in the last months; however, Anchor authorities were working on a scheme to reduce the yields paid on small investors’ deposits.
Having checked the reality of the project until April 2022, in the following articles we will analyze the fall and the legal implications it has.
