Luna UST plunges 99% – What is going on? Should you buy Luna?

 

In a week that was action packed with events, the standout event will have to be the death of Luna / UST.

This is one for the ages… that we’ll still be talking about years from now.

It has broader implications, so it’s important to understand what happened.

  

What happened to Terra (Luna) / Terra USD (UST)?

Here’s the 5 day chart of Terra (Luna).

It’s nothing short of complete destruction.

What was formerly the 4^th largest cryptocurrency just 1 month ago, has now plunged 99.9%:

Here’s the stablecoin TerraUSD (UST).

Remember that the people holding UST believed that they were holding something as good as USD.

Which now very clearly isn’t – down 82% as we speak:

To really understand this and why it matters, we need to start at the top.

What is a Stablecoin?

If you want to transfer USD to anyone today, you need to use the banking system.

Just ask Russia, North Korea, or Iran.

Even for the more law abiding out there, the USD banking system comes with its own set of intricacies and quirks. Not to mention hefty fees.

To get around all this hassle, the crypto community came up with the concept of a stablecoin.

Basically, it is the crypto version of USD.

1 Stablecoin = 1 USD, and you can transfer it freely using crypto networks, without all the hassle that comes with the banking system.

Types of Stablecoin

But how do you actually create a stablecoin?

There are 3 ways:

1. Fiat Pegged Stablecoin
2. Crypto Backed Stablecoin
3. Algorithmic Stablecoin

Fiat Pegged Stablecoin

The simplest form of Stablecoin.

Tether (USDT) is the best example.

Each Tether is backed by 1 USD.

So if there is 1 million Tether out there, it means there is 1 million USD in a bank somewhere that backs up every single Tether in circulation.

Of course, there are many people who dispute this (that Tether is fully backed), but that’s a story for another day.

The advantage with Fiat Pegged Stablecoins is that they are very simple and straightforward.

The drawback is that you need to store the USD somewhere, and banks are not very fond of helping the crypto community.

And it also limits growth, because you cannot issue more Stablecoins without first getting more USD.

Crypto Backed Stablecoin

The logical improvement, is the crypto backed stablecoin.

Instead of backing it with fiat currency, you back it with cryptocurrency.

Say Bitcoin, or Ethereum.

And because cryptocurrency prices are very volatile, you need to overcollateralise it.

So for every 1 USD stablecoin, you may hold 1.5 USD worth of Bitcoin/Ethereum.

The best example of this is DAI (Maker Dao).

The problem with Crypto Backed Stablecoins are pretty similar to fiat backed stable coins.

You solve the problem of having to store USD, but you still have the problem on growth.

Because you need to overcollateralise, it limits growth.

Algorithmic Stablecoin

If you think that the above tracks the evolution of fiat currency (paper money), you are exactly right.

The next logical evolution then, is obvious to everyone.

Just as Nixon unpegged the USD from Gold in 1971, a few guys in the Crypto world figured why not do the same for Stablecoins.

Enter the Algorithmic Stablecoins.

These are not backed by any USD or cryptocurrency.

They are essentially backed by confidence.

And of course, Luna (Terra) grew to become the largest algorithmic stablecoin.

What is LUNA (Terra)?

There are 2 coins that you need to know:

1. TerraUSD – the Stablecoin
2. Terra (LUNA) – the token

The core premise, and this is crucial because it underpins everything that is to come, is that:

1 UST can always be redeemed for 1 USD worth of LUNA

And vice versa – 1 USD worth of LUNA can always be redeemed for 1 UST

Some Examples…

It’s easier to understand with a few examples.

Let’s say UST trades at $0.80

A savvy investor will buy 1 UST (at $0.80), redeem it for 1 USD of LUNA, and sell the LUNA for a $0.20 profit

More Examples…

Let’s say instead UST trades at $1.10

The savvy investor will now buy 1 USD of Luna, swap it for 1 UST (worth $1.10), and sell the UST for a $0.10 profit.

All good so far?

Where is the incentive to hold UST?

Now to really drive demand for UST, you need an incentive right?

Enter the Anchor Protocol.

Basically – you earn 19.5% interest p.a. to stake (hold) UST.

That’s a pretty attractive interest rate, which drove a lot of demand for UST. There are reports of people converting their life savings into UST, and living off the 19.5% interest.

But of course, when something is too good to be true, it almost always is.

And if you’re asking where is the money coming from to pay the 20% interest?

Well, that’s exactly where the problem begins.

Structure works well on the way up (Luna price high)

The thing about this entire structure, is that it works very well on the way up, when Luna prices are soaring.

Let’s say Luna’s price is $1 million.

This means that every 1 Luna token can be swapped for 1 million UST.

That means a small bit of Luna is burned to mint a lot of UST.

UST supply is high relative to Luna supply, and the entire system purrs along.

Price of Luna keeps going up, and everyone is happy.

This was Luna for the past year.

Structure is unstable on the way down (Luna price fall)

On the way down though, everything reverses.

Let’s say Luna’s price falls to $0.5.

This means that I can take my 1 million UST, and convert into 2 million Luna.

The supply of Luna goes up exponentially, pressuring Luna prices on the way down.

Which means that Luna’s structure is inherently pro-cyclical.

It amplifies the move up, but it also amplifies any crash.

Enter… the Luna Central Bank

If it isn’t obvious to you by now, Luna is a confidence backed currency, no difference from the USD or paper money.

And with all confidence backed currencies, your biggest fear is a run on the bank.

The solution, which the US discovered 100 years ago – is to create a central bank.

Luna stumbled on the exact same solution.

Luna’s “Central Bank”, is the Luna Foundation Guard (LFG).

Why does Luna pay you 19.5% p.a. to hold UST?

Remember that Anchor Protocol pays you 19.5% p.a. to hold UST.

Why do they want to do this?

Very simply, the reason is that as more people hold UST:

1. LUNA is burned for UST
2. UST is staked (taken out of circulation)
3. LUNA price goes up
4. LUNA’s Central Bank (which holds a lot of LUNA reserves) sells LUNA to raise dollars.

And the hope is that:

1. UST takes off as a widely used stablecoin before LFG runs out of money paying the 19.5% p.a.
2. Luna price goes to the moon

Or to put it very simply, Luna pays you 19.5% to hold UST, so that Luna’s price will go up, so they can sell more Luna to raise money to pay you the 19.5%.

So FH… you’re telling me that Luna is a ponzi scheme?

I know this sounds exactly like a ponzi scheme, but to be really fair to them, so is the fractional banking system and the USD.

The only difference is that the USD has the US Government / Federal Reserve, and Luna only has LFG.

But if you go back into the early 1900s before the Federal Reserve was formed, you’ll find that the USD faced the exact same problems.

So these problems are not unique to crypto, they are a standard feature of currencies.

This is important to understand.

With the USD you have the US military and government to enforce restrictions if s*** hits the fan. Crypto for now… doesn’t.

Hence when things blow up, they blow up spectacularly.

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The Death Spiral

In any case, what happens next is fairly obvious to anyone who follows money generally.

The broad steps are:

1. UST is dumped
2. UST depegs from $1 due to selling pressure
3. As the peg is pressured, more UST holders start to panic and redeem their UST for $1 of LUNA to sell
4. The newly minted LUNA gets dumped, sending LUNA prices lower
5. Existing UST holders start to worry, so they redeem for LUNA to sell
6. Repeat until you have a run on LUNA

LFG will defend the peg

Of course, at this point the Luna central bank, LFG, starts propping up LUNA by selling its Bitcoin reserves.

Breaking the Bank of England… Crypto Style

But just as the Bank of England discovered 30 years ago, once the panic starts, it takes on a life of its own.

LFG eventually runs out of reserves and gives up defending the peg.

UST prices collapse:

As do Luna prices.

UST holders rush to convert their UST into Luna, which are then sold immediately.

This increases the supply of Luna exponentially, sparking hyperinflation in Luna.

Latest Updates on Luna

At some point in time, the Terra blockchain is halted entirely.

And Luna trading is halted on many crypto exchanges.

This is the death of Luna

There’s no sugarcoating this one.

Luna is in the hyperinflation phase of the Weimar Republic or Zimbawe.

When any currency enters this phase, there almost never is any way back.

The only realistic solution is to abandon the currency entirely, and replace it with a new currency that is backed by collateral.

In the past that would be gold or the USD, in crypto terms that might be Bitcoin or Ethereum.

Of course, it’s also possible that a white knight can come in with a massive cash infusion to save the entire project, but frankly it’s hard to see why anyone would want to do that.

This is probably the end of Luna in its current form.

I was lucky… sold my LUNA at $100 months back… but others are less lucky

Full disclosure that I hold no positions in Luna.

I was lucky to have exited my Luna positions completely at $100 a few months back.

And I say this without any trace of schadenfreude, because I know how painful it is to be burned by markets.

My heart goes out to all those who are affected.

Hearing some talk about suicide, and I really want to say, whatever it is – money is just money.

Nothing is worth taking your life over.

Move on, and build back stronger. Live to fight another day.

You can always make it all back again.

This is not the end.

Personal Views on Crypto

I’ve been saying this for a while, and I still think Crypto is in the early 2000s phase of the internet.

Lots of hype, lots of promise, and lots of crazy valuations.

Just like the Dot Com crash wiped out a whole generation of startups, the coming Fed Hiking cycle will do the same to many Crypto projects.

But those that remain, will be defined by this time, and will emerge stronger.

And over the next 10 – 20  years, perhaps we can start to see the FAANG equivalent emerge in the Crypto space. And which will change the world.

From a pure investment perspective, most of my holdings are in the “Blue Chips” of Bitcoin and Ethereum.

I still think they hold the best potential, at least for now.

Sure, the altcoins can be used to flip in and out to make a quick buck, but I wouldn’t hold them long term, at least not in this macro climate.

As always – love to hear what you think!

 

As always, this article is written on 14 May 2022 and will not be updated going forward. Latest thoughts (and my stock watch and personal portfolio) are available on Patreon.

 

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