You have probably heard about the cryptocurrency “$LUNA” which lost more than 99% of its value in just a few days. The purpose of this article is to explain as best we can what caused the cryptocurrency “$LUNA” to crash along with the sister stablecoin “$UST”.
To begin we need to establish a few terms that will be useful to your understanding later.
- Stablecoin: any cryptocurrency that is intended to track a traditional currency (such as the Euro or the US dollar), the majority of stablecoins are backed by a reserve in the corresponding currency. This means that anyone who intends to withdraw their stablecoins (i.e. exchange them for US dollars) should be able to do so at any time.
- Parity: The 1-1 relationship between a stablecoin and the traditional currency reserve which backs it.
- Loss of parity: any event that causes a discrepancy in either direction which invalidates parity.
“$UST” AND “$LUNA”: A DYSFUNCTIONAL RELATIONSHIP
Unlike the vast majority of stablecoins, the $UST stablecoin was not backed by a traditional currency reserve. Such stablecoins are referred to as algorithmic stablecoins: they are intended to follow pre-programmed rules as contained in a smart-contract. On the other hand, $UST’s sister cryptocurrency, $LUNA was not a stablecoin and was subject to speculation; including the advantages and disadvantages associated with such trades.
For example, if the price of 1 $LUNA was 2 dollars (USD) at any given time T, then one may sell 2 $UST to buy 1 $LUNA. Conversely, if we have 1 $LUNA and we want to acquire $UST we only need to sell 1 $LUNA to buy 2 $UST.
This relationship is implemented through a series of fairly complex algorithms to ensure that the $UST price is supported by the $LUNA. Furthermore, taking as an example 1 $LUNA = 2 dollars (USD), if we buy 1 $UST at 0.98 dollars (USD), this would mean that it would be profitable for investors to buy $UST and exchange them for $LUNA (the algorithm assumes that 1 $UST is equal to 1 dollar (USD) at all times), which will lead to a profit of 0.04 dollars (USD) without risk.
However, one of the fundamental principles of finance theory is that there can never be a guaranteed profit without an associated risk. In reality, everyone will attempt to obtain this return for themselves, which will cause the price of $UST to increase to compensate for this apparent “loophole”. In addition, part of the algorithm designed to augment confidence in cryptocurrencies allowed Bitcoins to be sold to buy $LUNA in order to return the $UST price to the theoretical price of 1 dollar (USD).
“$LUNA” CRYPTOCURRENCY CRASH: THE CHAIN REACTION
Let us return to the crash! The current theory regarding the crash is that investment funds (or wealthy individuals who had backed the cryptocurrency at the outset) began to gradually buy up $UST. These same funds and investors then without warning exchanged significant holdings in $UST for $LUNA before exchanging said $LUNA for dollars (USD), which in itself triggered the collapse of $UST and created significant quantities of $LUNA.
The sale had a negative impact on the $UST price (the law of supply and demand lowered the intrinsic value) which the algorithm was unable to compensate for, causing it to lose parity with the US dollar. As a result, $UST had a value of less than 1 dollar (USD), which meant that the perpetrators were able to recover a profit on each trade (buying $UST, exchanging $UST for $LUNA, selling $LUNA).
Furthermore, the relationship between the two cryptocurrencies means that to exchange $UST involves the “minting” of $LUNA: that is to say the creation of $LUNA. Therefore, the availability of $LUNA increases meaning that the price of $LUNA decreases with every exchange.
This sparked widespread fear in the market and, as a result, triggered a massive sell-off of $UST and $LUNA. The downward spiral which led to the collapse of this cryptocurrency. The question remains “are all algorithmic stablecoins vulnerable to such economic raids? Or can research lead to the creation of an algorithm that is capable of maintaining stability for these stablecoins?
In conclusion, we advise that you do your homework before investing any large sums of money in high-risk assets and under no circumstances should you invest any sums that you cannot afford to lose.