Learnings from the Luna / UST aftermath

The Bright Union team has been closely monitoring the unfortunate events unfolding relating to Terra, Luna, and the UST stable coin. The damage this has caused is beyond imagination. Second and third-order effects are yet to reveal themselves. Our thoughts are with the Lunatics and others affected. We sincerely hope that all will recover.

There is nothing new regarding the lack of safety in the crypto space. The amount of crypto stolen in Q1 of 2022 has already surpassed the total losses of 2021, according to Peckshield. Nearly all of these hacks and exploits are being performed within the DeFi space.

Last week’s incident, however, was of such magnitude that the crypto space as a whole experienced a setback, and regulators are expected to tighten their grip.

It is worth noting that not every stablecoin resembles UST; and not every cryptocurrency operates like Luna. Terra’s stablecoin design and marketing strategy was ambitious but ultimately fell short. And even though critics have pointed out the cracks of UST’s and Luna’s structure, it came to many as a surprise when Terra’s Achilles heel was exploited relentlessly.

We expect DeFi growth to slow down in the short term. TheTVL of DeFi dropped by almost 50%, and retail trust has been badly damaged. At the same time, this setback allows us to reflect on what the entire crypto community has built in order to come back stronger.

This article will explore the events that triggered the UST de-peg and Luna crash; and will reflect on what users and protocols can learn from them.

A short recap on Luna & UST

Terra ecosystem gained immense popularity through Anchor protocol, an app which provided attractive yields of nearly 20% APY to parties like retail investors, hedge funds, and crypto banks. Terra USD or UST stablecoin is different from other stablecoins like Tether and USDC, which should hold $1 in custody for every one blockchain-based representation. Conversely, UST is characterized by its decentralized and algorithmic nature.

LUNA, Terra’s main currency, allows users to burn their Luna in order to mint stablecoins pegged to various fiat currencies, with UST being the most important one.

The mechanism of minting and burning kept the UST tight to its peg of $1:

If UST rises over $1 because of an increase in demand, users are incentivized to burn $1 of LUNA to mint 1 UST to sell on the market for a profit margin. Because of steadily increasing demand, the UST supply generally increased while LUNA’s circulating supply decreased through burning, causing upward price pressure.

On the other hand, whenever UST falls under its intended peg, let’s say $0.98, the mechanism incentivizes users to burn UST, benefit from an arbitrage opportunity, and redeem 1$ of Luna for each UST.

If UST rose above $1, users were incentivized to burn 1 LUNA and mint $1 UST, expanding the UST supply.

If UST fell below $1, users were incentivized to burn 1 UST and mint $1 LUNA, contracting the UST supply.

Anchor’s Unsustainable Yield

While UST did enjoy healthy demand coming from p2p payment apps like Chai and Alice, the popularity of Anchor protocol is the main reason for UST’s surge. As a savings protocol, Anchor offered investors an almost 20% yield, an enormous difference from preceding and traditional saving solutions. A product so attractive sells itself — and it sold so well that UST and Luna became disproportionately dependent on Anchor.

Anchor’s yield was unsustainable as staking rewards came from a declining treasury. What started as an “efficient” marketing technique became a liability. The yield had to eventually come down. But how to decrease the yield without discouraging investors? After all, an en masse withdrawal of Anchor’s UST would flood the market with unproductive UST.

Opposed to UST’s that were generated to meet demand of increasing transactions, UST deposits into Anchor remained unproductive.

What was seen as a hurdle to overcome within the Terra community, became a reason for fear and doubt from outsiders. While UST slowly but steadily became the number one algorithmic stablecoin, and even surpassed BUSD in market cap, the robustness of its design became a topic for scrutiny and its flaws became apparent.

A sudden outflow of Anchor deposits, could cause a selling pressure too big for the algorithm to stabilize.

Murphy’s law in action

Terra Form Labs (TFL), the team behind Terra pushed for multichain adoption of UST in order to lessen Anchor’s dominance. Furthermore, the newly found Luna Foundation Guard also bought approximately $3 billion worth of Bitcoin and additional AVAX as collateral. This could be used as a last resort to defend the peg if it fell under $0.98.

Little did they know that it was precisely this Bitcoin Reserve that created a massive manipulation opportunity that would eventually be their downfall. The Bitcoin reserve made it worthy of attacking UST and profit from both a bleeding BTC and UST.

The rest is history… What we can easily say in hindsight is to remember Murphy’s law; whatever can happen, will happen. Terra’s LUNA could not cope with the amount of UST burned and all the newly minted Luna. Luna fell down from its all time high (ATH) of $119 to under a dollar long before UST could ever return to its 1$ peg.

Outcome: Overinflated Luna and bad-debted UST hanging by a thread.

While the Terra community is debating on Twitter about a possible revival plan, other crypto companies and investors should follow suit, taking note of what happened and introspect.

A paradigm shift towards risk mitigation

May 2022 coins itself as a month of mayhem, where countless investors were liquidated, DeFi funds imploded and suicide became a trending topic on Reddit as crypto investors lost perspective in life.

DeFi has been severely impacted and with investor confidence shattered, we expect the influx of new (institutional) capital to be limited, and the next wave of innovative projects will need to fight to secure appropriate funding.

The collapse of Terra/Luna showcases that we need a paradigm change in DeFI to be able to survive and thrive. We need to transcend to a new DeFi: a secure and de-risked industry with a sustainable and long-term horizon. Security and protection should at least be on parity with TradFi.

The entire ecosystem needs a paradigm shift towards risk mitigation and diversification. DeFi brings excellent opportunities, but black swans are always looming. Too many people have been blindly chasing unsustainable opportunities for too long, fueled by FOMO created by so-called KOLs and celebrity promotions.

Fundamentals over shortcuts

In recent times, projects whose marketing dominated other key aspects, like functionality and efficiency of the products, were rewarded. These projects based on shaky tokenomics, cheap tech, and unsustainable incentivization are destined to fail at some point. It is also evident that investors are already criticizing the yields of specific protocols favoring security. Projects undergo a real stress test as confidence is shaken and trust is broken.

“Reliable token pegging in the extremely volatile world of crypto requires much more conservative collateralization, than was done in the case of UST — Kiril Ivanov, Tech Lead Bright Union.”

Equipped with a critical investment lens we see investors favoring even deeper diversification. Rather than shady projects, their focus will shift towards projects actually solving fundamental problems and delivering value to users in a sustainable manner. Likewise, projects themselves should favor healthy growth rather than questionable growth strategies. Short cuts are not allowed anymore, and fundamental tech will prevail. The focus of projects should be on new user adoption rather than baiting them from the competition.

DeFi will come out better and more resilient

Opportunities should be evaluated based on risk-reward adjusted measures, and risk mitigation tools should be used when appropriate. As for many, diversification will not be enough and we expect a growing appetite for crypto insurance. Not only will institutions continue to adopt, but small investors will also crave coverage as insurance will be seen in a more favorable light after recent events.

However, we shouldn’t overlook the introspection needed within crypto insurance. After all, the insurance sector was able to piggyback on the success of Anchor. The popularity of Anchor covers massively increased coverage adoption; however, it also undermined the essence of insurance: risk mitigation.

Moving away from the UST debacle, we are confident that DeFi will come out better and more resilient: the use cases and benefits are all too powerful to go to waste. However, a momentous shift is needed. The unfolded events have sped up the likelihood and strength of regulation on DeFi, whereas we believe DeFi can and should self-regulate. Let’s use these unfortunate events as a catalyst to transform DeFi and web3.

About Bright Union

Bright Union is the world-leading multi-chain decentralized finance cover marketplace. Our mission is to safeguard your digital assets from hacks, smart contract failures, and rug pulls by empowering the crypto community to cover one another in a decentralized and permissionless manner.

Bright Union provides the most comprehensive range of crypto insurance on the market at competitive prices. Furthermore, Bright Union will soon release its unique suite of cutting-edge risk solutions, providing investors with outstanding investment and coverage opportunities. Be bright and take advantage of DeFi’s exponential growth.

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