The collapse of LUNA and UST in 2022 is considered one of the biggest disasters in the cryptocurrency field, with most of the causes stemming from the mechanism of the Terra ecosystem and its ‘bet’. Below is a summary of the causes and developments:
1. The mechanism of LUNA and UST
The Terra ecosystem is based on a combination of:
• LUNA: The main token of the Terra network.
• UST (TerraUSD): An algorithmic stablecoin “pegged” to the USD (1 UST = 1 USD) without relying on real assets like fiat currency or gold.
Mechanism:
• When the price of UST deviates from 1 USD, users can “burn” LUNA to mint UST, or vice versa, to bring the price of UST back to equilibrium.
• For example:
• If UST < 1 USD, users will burn UST to receive LUNA, reducing the supply of UST.
• If UST > 1 USD, users will burn LUNA to mint more UST, increasing the supply of UST.
2. The bet leads to the collapse
a) Abuse of Anchor Protocol interest rates
• Anchor Protocol, an application in the Terra ecosystem, promises extremely high interest rates (up to 20%/year) when depositing UST. This attracts many investors to convert their assets to UST to earn interest.
• However, this interest rate is not sustainable as it relies on reserve funds, and when the reserves are depleted, the pressure to maintain profitability causes the ecosystem to become increasingly unstable.
b) Coordinated attack
• The attacker executed a sophisticated plan:
• Selling off UST: A large amount of UST was sold off on DEX platforms (like Curve Finance), driving the price of UST below 1 USD.
• Creating a domino effect: The instability of UST's price causes many people to panic and sell LUNA to try to save the value of their assets.
• Exploiting the pegging mechanism: When UST was sold off, the mechanism of “burning LUNA to save UST” created extremely high inflation of LUNA. The amount of newly minted LUNA surged, causing the value of LUNA to drop sharply.
c) Death Spiral
• When the price of UST drops, many investors rush to sell LUNA, simultaneously decreasing the value of both UST and LUNA.
• LUNA was inflated to an uncontrollable level, from a supply of several hundred million tokens to trillions of tokens, making its value nearly meaningless.
3. The final outcome
• The price of LUNA fell from over 100 USD to below 0.0001 USD in just a few days.
• UST completely lost its pegging ability and no longer held value as a stablecoin.
• Billions of USD in market capitalization “evaporated,” causing severe damage to individual and institutional investors.
4. The role of Dev and Do Kwon
• Do Kwon, the founder of Terra, was criticized for his complacent attitude and failure to acknowledge the risks of algorithmic stablecoin mechanisms.
• Ineffective decisions in supporting UST (like using Bitcoin reserve funds to support UST's price) did not stop the death spiral.
5. Lessons from the collapse
• Algorithmic stablecoins carry extremely high risks if not supported by real assets.
• Unrealistic profits (such as Anchor’s 20% interest) often lead to collapse.
• Investor trust can easily be shaken when there is no transparent and stable mechanism.
This is a classic example of failure due to a lack of sustainability in the design of the cryptocurrency financial system.
