Terra Protocol and its ecosystem have been at the forefront of the cryptocurrency market for days without any reason. The protocol’s algorithmic stablecoin, UST, lost its peg and fell to around $0.30. Meanwhile, LUNA, another cryptocurrency in the ecosystem, has plummeted more than 90% in just a few days, reaching a low of around $4 (based on Binance).
This article tries to explain what happened to both cryptocurrencies and why it can be difficult to get out of this situation. To do so, it is important to understand how the algorithm works, which requires maintaining the 1:1 dollar peg of UST.
How does the UST Algorithm stablecoin work?
As described above, the protocol consists of two main tokens: Terra (UST) and Luna (LUNA).
Users can create USTs by burning Luna on the Terra Station portal. that much official documentation We provide a few examples that make it relatively easy to understand how the mechanics of the protocol could theoretically work.
Imagine the entire Terra economy as two pools. One for Terra and one for Luna. To maintain Terra’s price, the Luna supply pool increases or subtracts Terra’s supply. Users burn Luna for Terra and Terra for Luna, incentivized by the protocol’s algorithm. market module.
It is worth noting that this is conceptually different from regular stablecoins such as USDT or USDC backed by fiat or fiat equivalents.
For ease of understanding, we assume that the current price of UST is 1.01 USD. Users can then use Terra Station’s swap function to trade 1 USD worth of LUNA for 1 UST. The market will burn $1 of Luna and $1 of UST. The user can then sell 1 UST for 1.01 USD, earning 0.01 USD in profit in the process.
Now imagine the opposite. UST trades at 0.99 USD. Conversely, users can exchange 1 UST for 1 Luna USD. The swap burns 1 UST and mints 1 USD of Luna. The user gains 0.01 UST from the swap.
The greater the gap with the peg, the more profitable the arbitrage trade is. Theoretically, if the peg is lost and the UST price drops below 1 USD, users can burn the UST for LUNA and sell it for a larger profit.
However, this also means that the market cap of UST must be lower than that of LUNA. The reverse is because the hypothetical Terra bank run (read: exchanging UST for LUNA) means that some users will not be able to redeem a dollar worth of UST for a dollar value. Luna’s
Over the past few days, all of the above hypotheses have come true.
UST’s peg disappears and LUNA’s price plummets by more than 90%
Certain events have occurred over the past few days, causing a series of issues in the Terra ecosystem. This is the UST (remember – it has to be a stablecoin pegged 1:1 with USD), the chart looks like this (on Binance):
The UST price fell to a whopping 0.225 USDT on May 11th. In other words, the stablecoin has lost nearly 80% of its value in a matter of days.
At the same time, the LUNA chart looks like this:
The price plummeted to around $4 (by Binance) on May 11th, dropping about 90% over the past few days.
There are a lot of speculation as to why this happened, and CEO Kwon Do-Tera has yet to give an official explanation.
However, on May 9th he explained in a detailed thread that the Luna Foundation Guard Council has decided to deploy $1.5 billion of capital in BTC and UST to defend the peg.
1/ The LFG Council has decided to deploy a capital of 1.5 billion (BTC 0.75B, UST 0.75B) to alleviate market concerns over UST. Additional context on why and how: https://t.co/TfaAPkzgUJ
— Kwon Do-kwon 🌕 (@stablekwon) May 9, 2022
Two days later, with much greater volatility than expected, UST is trading at 50% of its fixed value and LUNA continues to plummet.
The problem is that as long as the price of UST is below the peg, it creates an arbitrage opportunity for users to burn UST and issue LUNA. Do Kwon has already mentioned that they are working on recovery plans, but nothing is official at the time of this writing.
Recovery plan announcement imminent for $UST. hold on tight
— Kwon Do-kwon 🌕 (@stablekwon) May 10, 2022
In essence, this arbitrage opportunity will not exist until the UST value is restored to $1 peg, thus creating a loop where LUNA can always be obtained at a discount through Terra Station.
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