What The Hell Happened To Terra (LUNA) Today?

The price for LUNA fell a mind-blowing 97.7% on the 11th of May 2022 following an arbitrage exploit for UST — an algorithmic stablecoin provided by LUNA, which de-pegged from its usual $1 price. UST reached a low of $0.2 before climbing back up to $0.61.

The drop led the LUNA team to sell $1.5 billion of their Bitcoin reserves, flooding the market with bitcoin and causing the entire crypto market to dip a further 30%.

This is an unprecedented and wild ride for any LUNA holder, and definitely a unique event that will go down in Cryptocurrency history, and will be remembered years from now.

How did it happen?

The Terra Protocol uses a combination of open market arbitrage incentives and decentralized Oracle voting to create and track stablecoins of any fiat currency. Users can spend, save, trade, or exchange Terra stablecoins instantly, all on the Terra blockchain. Their most popular stable asset is TerraUSD or UST for short.

The protocol that helps stabilise UST consists of two different pools: TERRA (the stablecoin — UST) and LUNA, the governance token.

UST, or the stable asset is algorithmically regulated with the help of the community. For example, if the UST price were to fall to 0.99 – LUNA holders would be able to burn UST in exchange for 1$ worth of LUNA, and earning the arbitraged difference (.01 in this example).

Conversely, is UST was overvalued, trading at 1.01 UST, users would be able to profit from that by Burning LUNA to mint more UST and earn the $0.01 arbitrage difference.

Therefore, LUNA relies on its users to keep the price stable, by arbitraging the difference away. In order for this system to work, there should be a large pool of users capable of consuming whatever amount of UST the market throws at them.

Because UST is not really backed by another underlying asset — dumping a significant amount of UST on the market can depeg the stablecoin, if LUNA governance do not have enough buying power to immediately arbitrage the difference.

And that’s exactly what happened.

Someone dumped $84m UST on the market, TERRA devs got concerned and removed $150m of UST liquidity from Curve. This created ripples, and thus more UST dumping ensued.

This is where the arbitrage exploit started to bring the whole system to its knees. At this point the price was already $0.8 for 1 UST. Meaning that each time someone burned a UST to mint a fraction of a LUNA token, they would earn $0.20.

People essentially kept on exploiting this arbitrage mechanism until both LUNA and UST nearly lost their entire value.

However, this is probably a short-lived exploit so don’t expect to still be able to profit from the arbitrage.

But what about the crypto crash?

They’re all connected. LUNA had to sell over $1.5 billion in Bitcoin to and prop the UST price. The massive selloff has had a snowball effect on the crypto market. Welcome to the beginning of the 2022 bear market. It’s going to be wild ride.

The future of LUNA and UST

We’ve seen the dangers of an untested algorithmic pegging system. It may be a trial by fire for LUNA, and definitely a lot more pressure than the team or any of the holders deserved. As a decentralised alternative to USDT — it did, and still does have have potential.

If LUNA are going to rebuild public trust, we need to see that they have addressed all of the flaws in their algorithmic rebalancing system, and that the potential fixes have been tested and validated before deployed to the live environment.

Some potential fixes include

An automated emergency reserve fund, that automatically deploys once an inordinate amount of UST drops on the market. (Accumulating more BTC could do the trick)

Limitations on the amount of UST that can be sold. This one is controversial as LUNA promised not to impose limits on its transactions, however, this has proven to lead to a serious situation for the dollar-pegged UST.

Partial order filling, or pending orders while enough funds are being pooled together to cover for a big transaction.

There are ways to stop this from happening, and to rebuild public trust. There will always be unknowns, unique situations and edge-case scenarios that were never considered. The important thing is no never stop building.