LUNA has dropped from a Top 10 coin to outside of the Top 140 in just a few days. Ever Wondered Why?
LUNA's main purpose is to act as a token for UST's survival. The point of the Terra blockchain was always to issue decentralised stablecoins. To issue 1 UST (supposed to be worth 1USD), you'd burn $1 worth of LUNA
When demand increases, it's positive for LUNA's price. In fact, we saw it rise from less than a dollar to over $100 in 2021.
Why? Because UST demand was high, which led to a lot of LUNA being burned (small supply + higher interest = higher price). But how did UST get that much demand?
Anchor marketed "20% APY on your stablecoin" which led to a lot of demand. However, that yield was not sustainable and at a certain level of UST, they had to reduce it. By doing so a lot of UST was flowing out of Anchor and being sold.
In turn, UST started to lose its peg and dropped below $1. At one point, the stablecoin dipped all the way down to $0.19
But how does a stablecoin become unstable?
To understand this, let's first look at what a stablecoin is. (UST is complicated, so for now, we'll be talking generally instead of specifically about UST).
A stablecoin is a crypto coin whose value is 'pegged' to a stable asset. The simplest way to peg a token to a dollar, for example, is to hold 1 physical dollar for every token in circulation.
However, stablecoins don't just stockpile dollars to back their tokens. They usually try and diversify by using other assets (Bitcoin, Gold, property) to help maintain the reserve's value.
Stablecoins may also peg using an "algorithmic" method. In this case, a smart contract is used to maintain the 'peg'. However, this method usually fails when volumes are very high, as if many withdrawals are attempted at the same time, it shocks the system.
Think of it like a 'bank run'. This is when everyone runs to the bank to withdraw their money because they believe the bank is about to close. The bank doesn't actually have all the money in hand, so everyone won't be able to withdraw their full amount.
As the bank run occurs, the 1:1 relationship is lost. As everyone knows their stablecoin should be worth $1 but they are now getting say 47 cents on the dollar, they look to try and exit.
This action continues to spiral, and in turn, the next seller will be forced to take say 46 cents on the dollar and so on. This further escalates the departure from the 1:1 peg.
Okay, so what about LUNA?
Remember how to issue 1 UST you'd burn $1 worth of LUNA? Well, the same applies the other way around.
When you want to "redeem" LUNA, you burn 1UST and issue $1 worth of LUNA. This inflates the supply relatively quickly in a bank-run style event as we mentioned above, leading to a massive decrease in price.
(If you've listened to our weekly AMAs, you may have heard us say that we're not fans of LUNA's mechanism to issue stablecoins as it is very reflexive, and now we're seeing it unravel.)
What's next?
Well the UST peg must be restored and right now we're seeing Terra ask for $1B to help restore it. If they do, it would be great for LUNA (in the short term, but long term the model has proven to be broken). If they don't succeed in restoring the peg, then it's going to be game over for Terra.
We're always here to help
For anyone who has lost a massive sum because of this chaotic event with UST, feel free to reach out to us - our DMs (Instagram/Twitter) are always open.
It's hard right now but you'll make it through the other side and there are plenty of opportunities in crypto.
This asset class is here to stay and your work will pay off.
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