LUNA + UST: $50B wiped out!😵
Unfolding the events that led to this disaster
Hello friends! 👋
Not a pleasant week for people in crypto but lots to learn and understand. This is the most spectacular crash of a project we’ve seen in this space. Imagine a $50 billion company going bust over 3-5 days!! This would draw a lot of attention and unfortunately, many folks have suffered. There have been (unconfirmed) cases of suicide by folks who were holding big bags of Luna and UST. People have been posting their grievances on this Reddit thread.
I’ll explain what happened behind the scenes that led to this catastrophe and to the downward spiral of the entire crypto market. This is a wild wild story and the sequence of events could well make for a thriller movie. But before that, some background information to help understand all of it.
Terra
Terra is an application-specific public blockchain built on the Cosmos SDK & Tendermint to offer algorithmic stablecoins. In simple words, Cosmos (Layer 0 infrastructure) allows anyone to build their own blockchain that could be application-specific with their own custom consensus mechanism. This is different from Ethereum which is a Layer 1 blockchain with its own set of rules. Developers are welcome to build applications on top of it but will have to follow the security and consensus mechanism of Ethereum.
Stablecoins
So Terra decided to build its own custom blockchain using tools offered by Cosmos and they built it for the purpose of creating an algorithmic stablecoin. A stablecoin is simply a coin/token that is backed by real-world assets such that its value is pegged to the USD. A stablecoin, by definition, must have a value of $1 and not fluctuate like other crypto coins. Examples include USDT, USDC, FRAX, DAI, etc. USDT and USDC are centralized, i.e., they are owned by companies that hold assets (equities, cash reserves, etc) to back the digital version of their coins. In contrast, FRAX and DAI are decentralized stablecoins as no central authority owns the assets. There are protocols that issue these tokens and the assets are held on smart contracts and they can be changed/executed only once a governance proposal is passed by the community.
Algorithmic v/s Collateralised Stablecoins
All these stablecoins we talked about are collateralized and in some cases, over-collateralized. This implies there’s inefficiency since $100 of USDT or DAI is backed up by $110 of real assets. However, this also ensures that stablecoin can retain its peg in case of a bank run. These protocols are trading capital efficiency for security.
Now, Do Kwon, the leader of the Terra community wanted to build an efficient system and decided to create UST (TerraUSD) - an algorithmic stablecoin that is not backed by any fiat-pegged currency. It maintains its peg via a system of arbitrage and protocol mechanism. How? Let’s dive into it.
Terra tokens and their interdependency
The Terra ecosystem has 2 tokens - UST (the stablecoin) and LUNA (the governance, reserve asset, and native staking coin). Let’s see how this works.
Owing to the price of Luna and circulating supply, the market cap (no. of tokens * price of each token) of Luna is higher than the market cap of UST. This is also desirable since LUNA is a reserve asset.
Interestingly, there is no limit on how many LUNA tokens can exist so the price of the token plays an important role in maintaining the market cap difference.
This dynamic is maintained by burning (removing from the supply) LUNA tokens to create UST. The dollar worth of LUNA decides how much UST can be minted. For example, if LUNA is trading at $100 and I want to exchange 10 LUNA tokens for UST, I will receive 1000 UST in return. And since LUNA gets burnt, the reduction in supply drives the price up.
Also, users can redeem 1 UST for $1 of LUNA. People keep selling and buying UST and that leads to price differences which are stabilized by arbitrageurs. For example, if UST trades at $0.95, traders will buy it for cheaper and redeem it for $1 of LUNA and sell it to pocket the difference. Similarly, when the price of UST rises above $1, let’s say $1.05, traders will burn LUNA and sell UST at a higher rate ($1.05) to pocket the difference ($0.05/UST). This whole arbitrage game is what was supposed to stabilize the price and maintain the peg. This is what they mean by algorithmic stablecoin.
Role of Luna Foundation Guard (LFG)
Since the primary mission of Terra is to drive the adoption of UST, they started offering yields on Anchor Protocol. If you deposit UST on Anchor, you get 19-20% APY of guaranteed returns. This is significantly higher than what banks offer. Terra was making 8-10% from loans that it gave out to depositors but the remaining 10-12% was subsidized. The Luna Foundation Guard (LFG) has a war chest that funds this unsustainable return so clearly at some point it had to stop but no one knew when. At the highest point, Anchor had deposits north of $14B+ in UST because users figured it was risk-free money. This essentially locks up UST so there’s less UST available on the open market which eventually drives the demand for UST and hence the price of LUNA up since LUNA can be burnt to mint UST.
In March this year, LFG and Do Kwon decided to buy Bitcoin worth $10B+ by selling UST to use that as a backstop in case UST were to ever de-peg. The idea was to use BTC to buy up UST in case UST ever de-pegs. The goal has always been to maintain the sanctity of UST even if it means LUNA goes to 0. LFG bought BTC at an average price of $42k-47k. This news drove the price of LUNA further up.
The Attack
The US Federal Reserve announced a hike in interest rate in April and the market plummeted. Come May, the price of 1 BTC is down to levels of $32-$38k.
Now, there’s a protocol called Curve Finance that has pools where people can deposit their stablecoins and earn sustainable yields. UST was a part of one of those pools - wormhole 3pool. Do Kwon and his team was promoting a new pool called the 4pool where 3 other stablecoins would be in the mix so they started to pull out liquidity from 3pool to deposit into the 4pool. This is when liquidity dried up in the market and they were vulnerable to an attack.
Some unknown entities with a massive war chest borrowed 100k Bitcoins (~$3.5B) from an unknown exchange and offered to sell a part of it to Do Kwon who wanted to buy Bitcoins in exchange for UST. This trade was supposed to happen OTC to avoid moving the market. Do Kwon took the bait and now the attacker had UST worth $1B. They immediately start to sell 350M UST in the curve pool (the 1st phase of attack) which destabilizes the peg due to massive supply compared to the supply of other coins in the pool.
LFG notices that someone is selling loads of UST and moves to sell the BTC it had acquired back in March and April to buy up the excessive UST in supply to stabilize the peg. Now, the attacker had a lot of BTC left even after exchanging for UST which they now started dumping on the market which tanked the price of BTC as well. This led to LFG selling their BTC at a rate of ~$34k which they previously acquired for ~$44k. Their reserves suffered massive losses.
The smart and sophisticated investors - large funds, take notice of this manipulation and decide to pull out their UST from Anchor Protocol. They figured something was wrong and that UST could lose its peg. Meanwhile, the attackers still had 650M UST which they now moved to Binance and decided to sell in lots of $300M!! This led to a massive sell pressure and the peg dropped to $0.97. Now the funds who took notice of this either started selling UST to get out or redeem their UST for LUNA. This is where LUNA takes its toll. The funds who redeemed UST for LUNA started dumping LUNA on the market to get their money out of the ponzi. The retailers now took notice and started selling theirs too. It was a game of who could get out first. This pushed LUNA and UST into a death spiral and there were more sellers than buyers eventually, and LFG ran out of ammo to support the peg. The peg fell to $0.60 and LUNA tanked from $100 to $1 - a 99% drawdown in a matter of 3-5 days!
The overall selling of BTC, UST, and LUNA across the board tanked the entire crypto market. At the same time, there were leveraged traders out there who got liquidated due to the massive sell-off and we saw liquidation numbers run into billions!!! This is precisely why we have a bearish market right now. The possible reason for the sell-off of the other assets was to cover up the losses incurred from LUNA and UST. Meanwhile, a lot of retail investors had no clue what was happening and by the time they realized, they lost not just their investments but savings too. The combined market cap of LUNA and UST was worth $60B+ of which $50B+ got wiped out.
You might be wondering what did the attacker get out of this. Remember they borrowed 100K BTC from someone? They obviously had to repay it and now given the market had tanked, they purchased 100K BTC at a significant discount, repaid the loan, and netted the profit (~$800-$900M)! This was a masterstroke!!
Takeaways
After this collapse, most people realized how risky this space is and that one cannot treat this like equities or Mutual Funds where you deposit money and forget about it. This strategy can and will vaporize your entire investment. It is important to research and understand how the economics of that ecosystem works before putting money into it.
If something is too good to be true, it probably is.
We’re probably better off sticking to the Top 3 coins than putting significant money into hyped projects. It works out well when one knows the correct time to exit which most people do not so better to stay away from these projects. The complexity behind this project was the reason I never put my money into it nor did I recommend buying on this substack.
There were some idiots who thought buying LUNA at $10 or $5 or even $1 made sense. Without understanding why Luna was tanking, people did put money in after a 90% drawdown and then saw their portfolio dive another 90%. No wonder the community called itself LUNAtics. It’s a lesson for all to learn.
In my opinion, the chances of a comeback from UST and LUNA are feeble and even if they make a comeback, the trust is lost and I don’t see any meaningful adoption for these tokens. The blockchain itself is now prone and easy to attack since it is no longer decentralized.
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