The Terra ecosystem including Luna, UST, and the Anchor Protocol all crashed: Explained

Luna, UST,
pic credit: TechStory

I felt a need to talk about Luna and especially the UST collapse. What happened? How I personally incurred crazy losses and the rumors swirling around that this is some kind of intentional market manipulation. This event has ruined tons of people’s lives and undoubtedly hurt the entire crypto market. And you’ll see what I mean in a minute. I really don’t even want to be writing this article.

So let me just give you the essentials first.

So UST, it’s a stable coin. It’s supposed to be pegged to the US dollar. This happens through arbitrage trading where investors essentially trade UST for Luna or vice versa to keep that price right at $1. Now, typically this works. It’s had a few slip-ups in the past, but nothing it hasn’t recovered from. Every time there’s been a slip-up, it’s been because the market tanks or something like that. But these things are made to withhold market events, so typically it’s fine.

Well, as you’re aware, I’m sure UST is now trading at far less than a dollar, around thirty cents at the time of writing this article, and it’s been as low as $0.29. Now, the worst part is that people buy and invest in UST and other stablecoins as a bit of a shelter from volatility and risk. You park your money there when you’re trying to be safe. Like that’s supposed to be the safe option.

The best way to visualize this is extreme inflation, which is real inflation, it’s pretty bad today also, but inflation that doubles overnight. So coffee was $3 yesterday. Well, it’s $6 today and there’s a chance it could be $12 tomorrow. This is essentially what happened to every single UST holder and there are millions of holders. This is huge.

So what caused all this?

Well, at the beginning of the month, Anchor Protocol, which was the most popular lending platform on the planet, switch its rate structure here, you could lend out the UST stablecoin token for around 20% APY. Crazy rates. The problem is that this was more of an introductory rate to get people in and build up excitement around this ecosystem. Rates would be lowered later.

They were burning a ton of cash and this couldn’t go on forever, which is totally fine. If cash ran out, rates would just drop. But your deposit would have no issues whatsoever. At the beginning of May, a new rate structure was enacted that would make rates more variable depending on demand.

Within that protocol, rates were expected to lower by about 1.5% per month for a few months until that stability was found. And then they weren’t burning so much cash. So this started and the expectation was that people who had money deposited on this Anchor protocol earning interest would leave, some people would and the exchange would be spending less money. The opposite happened.

Deposits hit a record high in early May after that switch to around $18 billion. But again, this wasn’t the end of the world. I personally kept an eye on it, but I wasn’t exactly worried about this, because again, the money runs out. It’s fine. However, we’re in a touchy market right now. Stocks are going down, cryptos, everything. There’s a ton of fear in everything having to do with investing.

People in the general market began to sell cryptos, including the one that backs UST, Luna. The decrease in Luna’s price caused investors to be concerned about its ability to back the value of this now massive UST token. It’s a top ten token. Now, some investors began selling their UST, and this caused a ton of downward pressure on UST because the algorithmic, it can go down in value.

This took it off of that $1 peg. So it went from $1 around May 7 to around $0.99. Again, this wasn’t the end of the world. Stable coins fluctuate. Even USDT fluctuates a little bit. Just recently, UST was trading at $1.01. No one batted an eye. It was totally fine. So things were a little bit touchy, but so is the entire market. So this didn’t seem like that big of an issue, really. That is until Monday when the Fed announced the interest rate hike. And this caused stocks and crypto to tumble dramatically and almost instantly.

People worried about further losses in the market began selling, including the Luna token and UST. So this caused a kind of negative flywheel where Luna’s price decreases further. And remember, Luna is backing UST. So people get even more worried that the value behind this stablecoin is crumbling. This means even more sell-offs happening. And you can see this kind of negative effect happens because of these sell-offs.

UST falls further off of its $1 peg, selling off more and more because now people are freaking out. It hit $0.98. People are like, I’m done with this. You can see that negative effect compounding. We can see the market cap of UST dropping dramatically right at this time. This is where prices begin to absolutely free fall. And I’m not going to lie, this was a very panic-inducing time.

I saw Luna live drop by 50% in what felt like minutes. I watched the price for UST, which is supposed to be a dollar, dropped down to $0.80, then $0.70, and then $0.60. And there’s nothing I could do about my deposits at this point. The network was congested. By the time I could get any money onto an exchange, this thing could hit zero, evaporating my account.

Anyone who was using leverage was very likely liquidated, especially by this point. If you had even 10% leverage, it’s not looking good. And that’s a lot of people but what’s especially frustrating for me? Before I ever bought a single dollar of UST personally, I did an insane amount of diligence to determine if this risk-reward made sense. I understood the tokenomics and the key risk factors. I’m diversified. I really like to do research before I buy anything.

The consensus seemed to be that UST would be totally fine as long as Luna doesn’t drop more than about like 70%, which seemed like a reasonable margin of error to me. Well, guess what happens? Luna dropped 70% and then some. Surprisingly, it didn’t go to zero the first night, but I was still looking at larger losses than I’ve personally ever seen before. This was money. I’m sitting on the sidelines waiting for good deals while the market was just being crazy. I was trying to be relatively safe with it.

So I keep my money in not wanting to be the guy who sells a dollar for $0.50. Because that sounds ridiculous. Who would do that? And I know that’s perfectly possible for the price to go back up to one dollar. With an understanding of how this price goes back to $1, I even decided to try some arbitrage. I should be able to essentially buy UST for $0.70 or whatever it’s at, and then sell it to Terra for a dollar instant 30% profit or whatever that difference might be.

This was a major problem though because they have a safety mechanism that makes it less profitable to do arbitrage the more that it’s being done. So it creates this kind of like cooldown period within the system. Now, in normal times, this is pretty useful, but right now this means my $1 tokens are stuck at far less than $1 for the foreseeable future.

Meanwhile, the backing Luna is getting pummeled, increasing the risk more and more. As the price of Luna goes down, this risk goes up. Plus that cooldown period just isn’t happening fast enough. This is insanely bad, as the crypto version of the housing bubble. So the next day comes and I know that we’re completely walking on eggshells here. If the crypto market drops further, we’re screwed. Absolutely a total bank run.

But if we can be calm, prices will go back up to a dollar, maybe in a few days, maybe a week at most. So I monitor the market and sell a little bit at like $0.90. But things seem to be healing up. So the plan was just to hang tight just a little while longer to see where things trend. That was a mistake.

Late on the 10th, prices began to tank further and further, hitting eventually around $0.20 for UST, a dollar now worth $0.20. So thankful I didn’t panic selling during that time. But I do have sales around $0.50 on a dollar. Who would do that? I guess me. By far the most painful sales of my entire life.

So not only am I part of one of the worst events, Black Swan events, to happen in crypto, but now I’m thinking about how I feel obligated to be transparent and talk about it like someone has to talk about these events and think about this. If I bought a volatile asset and it dropped 50%, sure, I’d be salty about it. But I’d think to myself, like, well, that’s the risk you take buying a volatile asset.

But when you buy something that’s supposed to be the safe bet, you know, reasonably safe anyways. It’s not perfectly safe. You just feel betrayed when it drops. And I’m sure there are a lot of people who kind of feel the same way as I do about this. You feel dumb. You think that you could have done something different. You think you should have done something different.

But the more I think about it, I really don’t think anyone who lost on UST should feel like they did especially anything like that wrong. This is the definition of a Black Swan event. This is the Lehman Brothers’ collapse of crypto. It’s not just degenerated who were part of this. It’s not 100,000% APY. Yes, it’s high APY. Don’t get me wrong. It’s a hint of degenerate, for sure. But we’re talking hedge funds were in this, retirement savings.

There were a lot of smart people who would invest in this, who got absolutely smashed. Every single person invested just didn’t properly calculate risk, myself included. And that’s the mistake that we made. And for those saying this is 20%, it’s unsustainable. What do you expect? You’re absolutely right. But so are lending rates on literally every single crypto platform. Every exchange that pays 8% to 12% flat interest on stablecoins is losing money in order to get people in the door. This is no different.

No one would expect an $18 billion to just essentially evaporate in two days. And that’s what happened. Now, I’m going to talk about what the future may hold here. But first I want to talk about the rumors that this may be a coordinated attack. Now, we don’t have proof of this, but I think it’s important to understand what’s being said anyway. So market conditions absolutely amplified this entire issue. But there are rumors that it might have been spurred by BlackRock and Citadel.

They borrowed 100,000 Bitcoin from Gemini, and the story goes that they then swap 25% of that into UST. They then reached out to Do Kwon, the founder of Terra, saying that they wanted to buy a large chunk of UST and would sell Bitcoin at a discount in order to do so. And they wanted to do it directly so they didn’t hurt UST too much. Supposedly, he took the bait, lowering the supply of available UST. Again, this has not been confirmed.

BlackRock and Citadel then sold all the Bitcoin in UST that they held causing both markets to fall sharply at the same time, creating this panic, or at least amplifying a panic that was happening. Once the price decreases, they then buy back the Bitcoin that they loaned out at a lower price and make a tidy profit on the loan.

Now the unfortunate thing is that if this is true, it’s totally legal. They were simply exploiting a market that had a major weakness. It’s extremely unfortunate, but it’s a weak market. There’s not much you can say or do. Some people did call that this could happen, and I even did to a certain degree. But we shouldn’t be too hard on ourselves, because if you look hard enough, you will literally find a prediction for anything.

So what now?

There are two major concerns that I want to point out, and then my announcement. Terra is voting to tweak the algorithm of UST to get the $1 Peg algorithm to work faster, getting the price back to normal sooner. This is good, but the issue here is that it will be at the expense of Luna. It will cause a lot of downward pressure. And even given this change, I foresee a ton of volatility in UST before it gets fixed. If it can even get fixed, the stress is not over if you still hold UST. In my opinion, none of this is financial advice, of course.

Now, second, this is extremely bad for the entire crypto market. Both crypto lending and stablecoins have had a close eye from regulators for the last year or so. I’m willing to bet that this is the nail in the coffin for both. This event is exactly why markets get regulated. Look at the bank runs of Black Wednesday, the ’08 crisis.

All of these things. People have their fun, they make their money, markets get hot, and eventually, the music stops. Then regulators need to come in and try to prevent it from happening again. But then there always will be a new market that crops up and the exact same thing happens. And we saw this coming. I highly recommend reading my last article about governments attempting to replace Bitcoin and stablecoins and the reasons to do so.

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