During a bull market all currencies went up, so it would increase in value then.
During a bear market, investors tend to retreat to stablecoins (since they don’t go down in value), which meant more would buy UST. As noted above, when new UST is created, LUNA is burnt in equal measure, so in theory, the value of LUNA still goes up as supply is decreased.
Unfortunately for those investors, they didn’t reckon on the downturn in May when demand for both LUNA and UST declined sharply, creating an irreversible death spiral for both currencies.
This was compounded by a change in the policy of Anchor Protocol, a kind of savings account for UST that had offered 20% returns and was a prime incentive for people to hold UST. Up to 75% of users staked their UST in Anchor Protocol, according to Coindesk.
Anchor Protocol announced in
March that this would become a variable rate, and people started running for the exits. One of the biggest was crypto lending business Celsius, which had half a billion US dollars in Anchor Protocol that it withdrew.
There was a big pullout of UST on May 9 (it’s not clear if this was co-ordinated or coincidental) causing the stablecoin to drop below its peg. In the space fax lists of just a few hours it dropped to US76c.
So, the algorithm did what the algorithm was designed to do: it minted more LUNA to buy UST and prop up the price.
The problem was that nobody wanted to buy that newly minted LUNA. The market was in poor shape, and nobody was buying.
The algorithm had to start selling cheaply and printing more and more LUNA to make up to difference.
Of course, investors took note:
they saw the de-peg, and they saw the sharp decline in the value of LUNA as new LUNA was being minted to try and restore the peg.
Confidence broke, and investors started pulling out their money as quickly as possible to try and salvage what they could, exacerbating the fall. The death spiral had begun.
As part of its custodianship of the Terra/Luna ecosystem, Terraform Labs had created the Luna Foundation Guard (LFG), headed by Do Kwon, that was designed to support the ecosystem and serve as a backstop in instances of a spiral.
Just weeks earlier the LFG had been boasting about buying large amount of Bitcoin to serve as a backstop to the UST peg. It said it had US$3.5 billion in Bitcoin reserves – one of the largest single holdings of Bitcoin in the world – that could be used to maintain the peg.
As Luna and Terra tumbled LFG said it had deployed the reserve (now valued at significantly less than it had been purchased for, since the value of Bitcoin had also declined due to the May market downturn).
Publicly, it was still bullish on restoring the peg. Just before the crash, Do Kwon posted this ill-fated tweet:
It turned out the LFG reserve barely made a difference
UST, which had slipped right down to 43c, did make a brief comeback to 80c, before resuming its fall.
Meanwhile, the value of LUNA was in freefall. In its desperation to try and restore the peg of UST, the algorithm was minting new LUNA tokens at a rate that would make the Zimbabwean Central Bank blush.
Before the collapse, there were about 340 million LUNA Tokens.
By the time of the network shutdown, there were some 6.5 trillion LUNA tokens in existence.
The jig was up. Tens of thousands of investors were left high and dry; the main Terra subreddit unironically pinned suicide and support helplines to the top of the page before closing the subreddit entirely.
As of the time of writing, Terraform Labs has made public statements about rebuilding the network – perhaps including a rollback to an earlier block – but confidence in the network was gone.
Could it happen again?
In the days following the collapse, a lot of questions started being asked about stablecoins in general.
Although backed stablecoins are a fundamentally different beast than algorithmic stablecoins, concerns have been raised about their, well, stability.
In theory, a backed stablecoin cannot lose its peg for long – unless the company backing it shuts down or starts refusing to redeem tokens.
Tether, the largest stablecoin by a considerable margin, has had ongoing questions about its claimed reserves.
The company claims it has reserves to match the currently minted supply of USDT, stored in a variety of asset types (including ‘commercial paper’), but it has not been publicly audited.
For many observers this is a ticking time bomb – Tether has become fundamental to the cryptocurrency ecosystem.
It’s the most common trading pair, serving as the ‘middleman’ in many exchanges of crypto, and is used for remittances between exchanges.
A collapse of Tether, likely caused by a ‘bank run’ where Tether cannot redeem the currency, could destroy the entire ecosystem for years.
It’s unknown how likely this is to happen. There are also backstops: USDC and BUSB are both audited and have proven reserves.