The LUNA and TerraUSD Crash

The LUNA and TerraUSD Crash

I am a professor of cryptography and not of “crypto” —and where the name “crypto” is now more than often linked to cryptocurrency. In fact, recently, the person holding the “crypto.com” domain finally sold it out for a rather large fee but had held out for years because he didn’t want it associated with cryptocurrency. My general interest in cryptocurrencies is focused on the cryptography used and in the algorithms that they use, and how digital trust can be applied to our world. But, I am also interested in the evolution of financial market places, and in the way it challenges our existing approaches.

So, before I outline how the LUNA and TerraUSD (UST) crash, I state that I am not an economics professor, so please forgive me for my understandings of areas of supply and demand, and of financial markets. So get ready to understand the difference between a state-backed tethered token (highly stable) and an algorithmic tethered token (inherently fragile [1]).

Algorithmic tethering

Anyone can create their own token. Basically, they conform with the ERC-20 standard, and are minted through a smart contract. They can then be traded with or without any value. Many companies have thus minted tokens which relate to a given service, and which can be traded in exchanges. One example of this is the LUNA token and which is associated with the Terra platform to develop stable coins, and where a stable coin aims to peg itself to a fiat currency:

For a state-tethered stable token, the token will be underwritten by bank reserves, but this is not the case for TerraUSD (UST), and which is underwritten by the LUNA cryptocurrency.

Terra

Terra was founded by Do Kwon, and has a number of native tokens, including LUNA and UST. On the back of the growing in value of its tokens, it was valued at around $15 billion in March 2022. [here]:

Unlike fiat currencies or state-backed tethered tokens, the UST stable coin is not underwritten by bank reserves, but by cryptocurrency reserves. With fiat currencies, in the past, it was gold reserves which backed currencies, but we have long since passed this type of tethering. With the Terra created stable coin, there are no gold reserves or actual cash — the reserve is a cryptocurrency with some value, such as with LUNA.

UST price is anchored with a smart contract, and where LUNA tokens are burned (destroyed) or minted (created). Within Terra, users are able to swap LUNO for UST, and at a pegged price of $1. During this swap, some LUNA are deteled and the remainder put into a treasury. This treasury is used to invest in the Terra ecosystem. This removal of tokens makes them more scare, and thus more valuable. When the price of UST tokens go up, more LUNA tokens are created, and which pegs the value back again.

The crash

And so LUNA has been used to provide reserves for TerraUSD and where LUNA has been generally rising in value over the past few months [here]:

When the value of the dollar goes down, there can be a withdrawl of LUNA, and where the dollar goes up, LUNA can be used be used to match the over value. This is all done through an algoritum. Over 2021, LUNA had moved from around $0.66 to more than $89 at the end of year. On 8 May 2022, LUNA was trading at $80, but there was a run on it, and in less than a day it dropped to less than a cent. TerraUSD is then tethered to the US dollar, and which is shored-up through the transferring of LUNA. So, when LUNA crashed, so did TerraUSD —as it could not keep itself pegged to the US dollar [here]:

Before it crashed, UST was the 4th most most valuable cryptocurrencies and with a market capitalization of $15 billion. But, there is nothing to stop both these tokens from reinflating themselves, but the confidence levels of LUNA and USDT are very low level at the present time. Other Terra-tethered cryptocurrencies, such as TerraEuro, also crashed [here]:

The TerraUSD (UST) should not be confused with USDT and which is issued by Tether. This is linked to reserves of $81.3 billion, of with 83.7% held in cash or cash equivalents [here].

Risks were known

The risks of using the Terra approach to tethering has been known for a while. In Oct 2021, Ryan Clements outlined that algorithmic stablecoins are inherently fragile and where set to fail [here]:

Ryan outlined that there are three core weaknesses with algorithmic tethering: the requirement for demand; market incentives for price stabilization; and reliable price information. In conclusion, he outlines that regulatory guidelines are required for algorithmically tethered stablecoins, including for risk disclosures and containment measures.

Conclusions

I have no cryptocurrency, and I don’t think I ever will. To tether a token to fiat currency, and then link that to another cryptocurrency, just seems silly. There must be some rights for consumers, and there is at least some insurance against a run on these assets. I must admit, I thought that these tether coins were linked to money in the bank, and not to other tokens.

We are still very much in a learning phase when it comes to building a tokenized economy for financial transactions. The work, though, towards tokenization of other areas of our work continues, and it will be cryptography which properly builds this.

Postscript

If you are interested in what happened with the “crypto.com” domain, try here:

References

[1] Clements, Ryan, Built to Fail: The Inherent Fragility of Algorithmic Stablecoins (October 28, 2021). 11 Wake Forest L. Rev. Online 131 (October 2021), Available at SSRN: https://ssrn.com/abstract=3952045 or http://dx.doi.org/10.2139/ssrn.3952045