The Fall of LUNA

Timeline of the Collapse:

Early morning, May 8: To prepare for the creation of the 4Crv pool, LFG withdrew $150 million in UST liquidity from the UST-3Crv pool. At that time, the TVL of the UST-3Crv pool was approximately $700 million, meaning that draining the pool entirely would have required only about $300 million.

To maintain the liquidity balance of the UST-3Crv pool, LFG further withdrew $100 million in UST from the pool.

Evening, May 8: Whale alert accounts on Twitter began issuing frantic “warnings,” reporting UST sell-offs every hour. The transaction amounts were consistently in the millions.

Morning, May 10: Jump Trading and LFG, possibly realizing that something was wrong, stopped selling Bitcoin reserves to defend the peg, allowing the situation to worsen. UST plummeted to $0.60.

May 11: UST appeared to have been targeted by a Soros-style (crypto equivalent) speculative attack. Continuous sell-offs drove UST down to as low as $0.2998 (according to CMC data).

The Panic of May 11—The Suspected Soros-Style Crypto Killer and the Deliberate Shorting of UST and LUNA:

Taking advantage of the thinning liquidity caused by Luna withdrawing from Curve’s 3pool to prepare for the upcoming 4pool, the attacker dumped $350 million in UST on Curve, breaking the peg. LFG sold BTC to defend the peg, but the attacker used the remaining UST to dump on Binance.

The severe depegging of UST triggered a bank run. To stabilize UST, Luna aggressively sold BTC, causing BTC to plummet further. Due to the seesaw mechanism between UST and Luna, burning UST required minting new LUNA, which increased LUNA’s supply and caused its price to crash.

The attacker’s estimated profits from shorting BTC and LUNA exceeded $1 billion, while the operational cost of dumping UST was estimated to be less than $200 million.

Impact on the Terra Ecosystem:

Due to the strong binding between Terra’s ecosystem projects and LUNA/UST, as well as the Lego-like reinvestment mechanisms and yields, UST’s depegging inflicted dual blows on protocols and token prices. It triggered protocol liquidations and caused a secondary death spiral for LUNA and UST.

1) Anchor

Anchor, as a decentralized savings protocol in the Terra ecosystem, was known for offering a stable annual savings yield of around 20%.

After UST’s depegging:

The Anchor protocol dashboard showed a deposit APY of 18.9%.

Total deposits plummeted from $14 billion last Friday to $3.99 billion.

Orion.Money, a supplement to Anchor and Terra’s ecosystem, aimed to facilitate the conversion of other stablecoins such as USDT and DAI into UST to participate in Anchor’s savings yields. By staking ORION tokens, users could achieve high APY rates of 10%, 15%, or 20%. Following UST’s depegging, the stablecoin staking on Orion's protocol dropped by more than 50%.

2) Mirror

All synthetic assets on Mirror were minted using UST as the primary collateral, serving as mirrors for various stocks, ETFs, and other financial assets. Consequently, any demand for synthetic assets based on U.S. stocks would ultimately return to UST, providing UST with its most direct use case and value for UST and LUNA.

Mirror's TVL on the Terra chain fell from $600 million to $240 million, a decline of 60%.

3) Lido and Node Staking

Lido, the largest liquidity staking protocol, had launched Terra node liquidity staking solutions as early as last year. It released the liquidity of LUNA staked in Terra’s ecosystem nodes.

The LUNA staked on Lido saw a decline of about 60% in value, leading to a large-scale sell-off.

Terra's staking TVL on Lido fell by 80% on May 11 and by 91% over the past seven days.

On the other hand, node staking directly affects Terra’s network validation and security. As of now, no large-scale node withdrawals have been observed. However, as UST continues to depeg, more LUNA is being minted, and LUNA’s supply is about to exceed 1 billion tokens.

4) Abracadabra

Abracadabra launched the Degenbox strategy for UST, allowing users to deposit UST tokens into the Cauldron to borrow MIM or leverage their positions. Through circular staking, users could significantly increase their yield. As long as UST remained at $1, this strategy was essentially risk-free. However, once UST depegged, users faced the risk of liquidation as the value of their collateral decreased.

Currently, the Abracadabra protocol is transferring all UST from Terra-based strategies back to Ethereum to adapt to current market conditions and focus more on liquidity and potential liquidations.

Related Reserve Pools:

Earlier this year, due to concerns over the death spiral inherent in the design of algorithmic stablecoins, the Luna Foundation Guard (LFG) established a reserve pool comprising Bitcoin and AVAX to defend the value peg of Terra’s stablecoin, UST.

Using BTC as an Example:

LFG originally intended to use BTC as a release valve for inflationary pressure. When exchanging UST for LUNA on-chain, the mechanism was designed to reduce the new supply of LUNA to control the occurrence of a death spiral, thereby enhancing the system's risk resistance. According to the on-chain mechanism proposed by Jump, 1 UST could be exchanged for $0.98 worth of BTC. If UST traded below $0.98 off-chain, market participants could purchase BTC from the reserve at a discount. This modified AMM mechanism was referred to as "THE DEFENDER." Before UST traded above $0.98, the best way to buy BTC in the market was through this reserve pool, which provided a hard price support for UST's peg.

Neither BTC nor AVAX was intended to serve as collateral. Instead, they were incorporated into the current mechanism for algorithmic stablecoins as a new approach. The original intention was to address the fragility of algorithmic stablecoins by anchoring them to more stable, high-quality assets, which indeed hedged against some sell pressure to a certain extent. While the story sounded promising, the mechanism to redeem BTC with UST/LUNA on-chain has not yet been implemented. However, under the current circumstances, UST's severe depegging further eroded the confidence of LUNA holders, plunging it into a death spiral.

LFG was forced to deploy its BTC reserves. Reportedly, LFG used 28,205 BTC, valued at approximately $1.3 billion, to provide liquidity to professional market-making teams to defend UST's stability. However, this was merely a drop in the bucket. The situation was further exacerbated by the U.S. Federal Reserve’s May 10 announcement of interest rate hikes and quantitative tightening. In recent years, the correlation between Bitcoin and the U.S. stock market has increased significantly due to traditional financial institutions entering the crypto market. Amid the stock market plunge and LFG’s large-scale Bitcoin sell-off, Bitcoin fell below the $30,000 mark.

Another Ecosystem Closely Related to Terra: AVAX

On April 8, Do Kwon announced that AVAX would also be included as part of UST's reserves and that UST would support native minting on the Avalanche blockchain. The idea was to leverage AVAX’s rich ecosystem to expand UST’s use cases. Meanwhile, the Avalanche ecosystem lacked its own stablecoin, making the collaboration seem like a perfect match. However, behind this seemingly ideal partnership lay hidden risks.

The logic behind AVAX and UST was similar to that of BTC. Both formed a virtual AMM pool. Users on Avalanche’s C-chain could exchange $1 worth of AVAX in the pool for 1 UST. Similarly, users could exchange 1 UST for $0.99 worth of AVAX. This asymmetric design created arbitrage opportunities, but such opportunities were only utilized when UST's price dropped.

Fortunately, AVAX cannot yet be directly used to mint UST. LFG merely announced that it had added $100 million worth of AVAX to the reserves through an OTC transaction with the Avalanche Foundation. Details of the transaction, such as whether the tokens were locked or the exact pricing, were not disclosed. During this turmoil, AVAX was relatively unaffected compared to LUNA. While LUNA suffered a near 99% collapse, AVAX fell by more than 20%, largely due to the overall market conditions.

This incident sounded an alarm for the entire blockchain ecosystem: Does every ecosystem need its own stablecoin? Compared to AVAX's decline, NEAR, which had launched its USN stablecoin earlier, suffered a greater impact. The loss of market confidence led to a broader collapse across the ecosystem.

Other Algorithmic Stablecoins:

The UST collapse triggered a trust crisis in stablecoins, extending to other stablecoin protocols. However, this also presented an opportunity to test the confidence of users in other protocols and the robustness of their mechanisms.

Looking at the peg stability of decentralized stablecoins (excluding centralized collateralized stablecoins such as USDC, USDT, and TUSD) before and after the UST collapse, no significant depegging was observed (using a 5% depeg threshold). Only HARD Protocol’s USDX saw a drop of approximately 8%. Other partially collateralized stablecoins, such as FEI and FRAX, did not show significant depegging.

However, UST's collapse undeniably shattered market confidence in stablecoins, particularly algorithmic and partially collateralized ones. Tokens such as FXS and SPELL were severely affected.

Developments:

Rumors suggested that Citadel Securities, a well-known Wall Street hedge fund, was behind the attack. Allegedly, they borrowed 100,000 BTC to short the market, breaking LUNA's pegging logic and triggering a vicious cycle.

Do Kwon initially sought external financing of $1 billion, offering LUNA at a 50% discount, but the proposal was rejected.

Do Kwon announced Proposal 1164, which passed with 35 votes in favor and 4 abstentions. The proposal accelerated UST burning, increasing SDR from $50 million to $100 million and reducing the Pool Recovery Block from 36 blocks to 18 blocks. This increased the minting capacity from $293 million to $1.2 billion.

Terra's Challenges:

As a Korean fintech payment company, Terra held substantial funds from large Korean enterprises in the form of UST, tied to legal obligations. Unlike LUNA, which involved mainly crypto-related funds, UST had broader exposure to non-crypto assets, imposing greater legal and financial responsibilities. If forced to choose, abandoning LUNA to ensure UST’s value would be inevitable. Without external funding, the only option was to continuously mint LUNA to burn UST, exchanging LUNA for more valuable assets such as BTC/USDT to stabilize the UST peg. Only by extracting LUNA's value to anchor UST could the stablecoin truly be saved.

As a result, LUNA is expected to continue its downward trajectory until external funding ends this tragedy.

Conclusion:

The goddess of the moon has indeed fallen.

As of the time of writing, LUNA was priced at $0.80, and UST was valued at $0.35.

This article does not constitute investment advice.