Here is What Happened to LUNA and Why the Price Can Continue Crashing

Terra Protocol and its ecosystem have been on the forefront of the cryptocurrency marketplace for a number of days now, and never and not using a cause. UST – the protocol’s algorithmic stablecoin – misplaced its peg and dropped to round $0.30. In the meantime, LUNA – the opposite cryptocurrency within the ecosystem – crashed by over 90% in a number of days to achieve a low of round $4 (on Binance).

This text makes an attempt to elucidate what occurred to each cryptocurrencies and why it is perhaps difficult to get out of this example. To take action, it’s necessary to grasp how the algorithm that’s supposed to keep up UST’s 1:1 greenback peg works.

How Does the UST Algorithmic Stablecoin Work?

As defined above, the protocol consists of two major tokens: Terra (UST) and Luna (LUNA).

Customers are capable of mint UST by burning Luna on the Terra Station portal. The official paperwork of the protocol present a few examples that make it comparatively simple to grasp how the dynamics can play out in principle.

Think about the entire Terra economic system as two swimming pools: one for Terra and one for Luna. To take care of the value of Terra, the Luna provide pool provides to or subtracts from Terra’s provide. Customers burn Luna to mint Terra and burn Terra to mint Luna, all incentivized by the protocol’s algorithmic market module.

It’s value noting that that is conceptually completely different than common stablecoins like USDT or USDC which are backed by fiat or fiat equivalents.

To make it simpler to digest, think about that the value of UST is presently 1.01 USD. Customers can then use the swap function of the Terra Station and commerce 1 USD value of LUNA for 1 UST. The market would burn 1 USD of Luna and mint 1 UST. Customers can then promote their 1 UST for 1.01 USD – profiting 0.01 USD within the course of.

Now think about the alternative – UST trades at 0.99 USD. Customers are capable of do the alternative – swap 1 UST for 1 USD of Luna. The swap burns 1 UST and mints 1 USD of Luna – customers revenue .01 UST from the swap.

The larger the distinction to the peg is, the extra worthwhile the arbitrage can be. In principle, if the peg is misplaced and the value of UST crashes beneath 1 USD, customers can burn UST for LUNA and promote at a larger revenue.

Nonetheless, this additionally signifies that UST’s market cap must be beneath that of LUNA’s as a result of the alternative would imply {that a} hypothetical Terra financial institution run (learn: redeeming UST for LUNA) would disallow some customers to have the ability to redeem $1 value of UST for $1 value of LUNA.

Prior to now few days, all of the above hypotheses grew to become actuality.

UST’s Peg Disappears, LUNA’s Worth Plummets Over 90%

Over the previous few days, sure occasions unfolded, inflicting a cascade of points for the Terra ecosystem. That is what the UST (keep in mind – it’s alleged to be a stablecoin pegged 1:1 with USD) chart seems to be like (on Binance):

The UST worth dropped to a whopping 0.225 USDT on Could eleventh, that means that what was meant to be a stablecoin misplaced nearly 80% of its worth in a number of days.

That is what the LUNA chart seems to be like on the similar time:

The value crashed to round $4 (on Binance) on Could eleventh, charting a lower of roughly 90% up to now few days.

Speculations are operating rampant as to why this occurred, and Do Kwon – Terra’s CEO, is but to give you a proper rationalization.

On Could ninth, Nonetheless, he defined in an in depth thread that the Luna Basis Guard Council voted to deploy $1.5 billion in capital – in BTC and in UST – to defend the peg.

1/ The LFG Council simply voted to deploy 1.5B in capital (0.75B in BTC, 0.75B in UST) to allay market issues round UST. Some extra context on why and the way: https://t.co/TfaAPkzgUJ

— Do Kwon 🌕 (@stablekwon) May 9, 2022

Two days later, and with much more volatility than what was maybe factored in, UST is buying and selling at 50% of its peg worth whereas LUNA continues to crash.

The issue is that as long as the value of UST is beneath its peg, this creates an arbitrage alternative for customers to burn UST and mint LUNA. Do Kwon already talked about that they’re engaged on a restoration plan, however there’s nothing official as of the time of this writing.

Near saying a restoration plan for $UST. Hold tight.

— Do Kwon 🌕 (@stablekwon) May 10, 2022

In essence, this arbitrage alternative gained’t stop to exist till the UST worth is restored to its $1 peg, therefore making a loop the place LUNA can all the time be obtained at a reduction by way of the Terra Station.