Luna and UST

In May 2022, one of the most spectacular collapses in financial history played out in slow motion over two weeks.

TerraUSD — UST — was an algorithmic stablecoin. Unlike dollar-backed stablecoins that hold actual dollars in reserve, UST maintained its $1 peg through a complex mechanism involving a paired token called Luna. The system worked through arbitrage incentives: when UST fell below $1, traders could burn it for $1 of Luna, and vice versa.

At its peak, the Terra ecosystem was worth over $60 billion. Do Kwon, its creator, was one of the most prominent figures in the crypto world. The Anchor Protocol — which offered 20% yields on UST deposits — had attracted billions from people who believed they were earning safe returns on a stable asset.

In early May 2022, large withdrawals destabilised the peg. UST fell to $0.98. The arbitrage mechanism kicked in, minting enormous amounts of Luna to defend the peg. But the minting created selling pressure on Luna, which fell in price, which required even more Luna to be minted, which fell further.

The death spiral took eleven days. UST fell to effectively zero. Luna, which had been worth $80, fell to fractions of a cent. Billions of dollars of ordinary people’s savings — some held as retirement funds, some as emergency savings — were gone.

The Luna collapse had nothing to do with Bitcoin. But it hit sentiment across the entire market and contributed to the 2022 bear market that followed.

The lesson, again: not all things called “crypto” are the same. Understanding what you hold matters enormously.

Tomorrow: FTX — the largest fraud in crypto history.

— The Daily Bit