Is Luna A Scam? [What Happened To Luna/Terra]

In what has proven to be a dramatic week for cryptocurrencies, the tanking of Terra’s UST stablecoin and token LUNA has been the biggest story.

This is significant because LUNA has been in the top 10 coins by market capitalization and it shed nearly all its value in a matter of days. UST did not do well either because it lost its peg to the dollar bottoming out at 13 cents (down from $1). It has not yet recovered its value.

In this piece, we’ll be taking a look at what happened to UST and LUNA, why it happened, and what impact it may have on the market as a whole.

Before I start…

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Table of Contents

What’s a stablecoin?

Before we even get to what happened to Terra’s two tokens, a fundamental understanding of how stablecoins work is a nice place to start.

A stablecoin is a cryptocurrency that is pegged to a more stable asset or currency, like the US Dollar.

Tether and USDC are two well-known stablecoins and they are both pegged to the US dollar. This means that if you have 1,000 USDC tokens, you can exchange them for 1,000 US dollars if the rates are where they ought to be in the ideal scenario.

Stablecoins are a key part of De-Fi (decentralized finance) systems. They serve many functions and one of the biggest ones is providing investors with a hedge against the volatility of the cryptocurrency market.

De-Fi is a financial system that does not have centralized organs of control like a central bank. This is still in its infancy and many analysts believe that it is where we are headed to as a civilization. We’ve covered this before in pieces like Crypto Cashflow and Defi Cash Machine.

Going back to the topic at hand, how does a Stablecoin offer stability?

The best way to understand this is to look at an example. If you have a cryptocurrency that is selling at $2,000, you can exchange it for $2,000 worth of stable coin.

If the cryptocurrency drops its value by 50% and now costs $1,000. You can now exchange your $2,000 worth of stable coin (assuming it retains its value) for the cryptocurrency. Now you will own two units instead of one.

Investors normally invest in stablecoins when they think that a downswing is coming. They do it to protect their wealth.

Types of Stablecoins

There are a few types of stablecoins and they are classified according to how they are collateralized:

Fiat-backed Stablecoins

The biggest stablecoins that are fiat-backed are 1:1 with the fiat currency. There has to be actual fiat currency held in reserve and it should remain proportional to the stablecoins in circulation.

If a platform has a reserve worth $100 million, they can distribute $100 million coins.

Crypto-backed Stablecoins

These stablecoins have another cryptocurrency as collateral. They achieve that by using smart contracts.

To buy this type of stablecoin, you need to lock your cryptocurrency (could be BTC, Ether, or another digital asset) into a smart contract.

Due to the volatility of cryptocurrencies, such stablecoins are usually over-collateralized.

For example, if you want to buy $1,000 of a stable coin, you may have to deposit $2,000 worth of cryptocurrency. The main reason they work like this is to maintain stability even when the cryptocurrency falls in value.

Commodity-backed Stablecoins

A commodity-backed stablecoin is collateralized by physical assets like precious metals, oil, and real estate. Gold is the one often used for collateral.

Algorithmic Stablecoins

Algorithmic stablecoins do not have collateral in the form of commodities, fiat currency, or cryptocurrency although their value is still pegged to a fiat currency.

Usually, they rely on algorithms and smart contracts to manage the supply of tokens in order to stabilize the price.

An algorithmic stablecoin reduces the number of tokens in circulation when the market price falls below the price of the fiat currency it tracks. The opposite happens if the price of the token exceeds the price of the fiat currency it tracks.

What is Terra?

Terra is a decentralized network for algorithmic stablecoins. It was created by South Korea-based Terraform Labs, which was founded in 2018 by Do Kwon and Daniel Shin.

It has two tokens, Terra and Luna. The Terra stablecoins track the prices of fiat currencies and Luna is for blockchain governance.

Examples of Terra stablecoins are TerraSDR, which tracks the price of the IMF’s SDR, TerraUSD (UST) tracks the U.S. dollar, and TerraKRW (KRT) tracks the South Korean won.

Since Terra’s stablecoins are algorithmic, they have a protocol that ensures that supply and demand are balanced (by using arbitrage). The platform uses Luna as a counterweight to the stable coins.

How does this work?

For example, if UST is trading at a price higher than its peg, it means that it has higher demand than supply. Therefore, the platform should increase supply to address the shortfall. It incentivizes people to mint Terra and burn Luna.

This lowers the price of Terra and increases the price of Luna (because the supply decreases). This process continues until the stablecoin goes back to its peg price.

Conversely, if Terra is trading at a lower price than its UST peg, it means that there is a higher supply than demand. The system works to reduce supply by incentivizing users to burn UST and mint Luna. The process repeats until the target price is achieved.

What is Luna?

As we’ve seen, Luna is the governance token on the Terra blockchain. It acts as the counterweight to the stablecoins and its job is to maintain price stability.

A few days before it crashed, LUNA was among the top 10 cryptocurrencies by market cap.

After it crashed, it shed nearly all its value causing shockwaves across the market, which is saying something because the cryptocurrency market in general is in a mess.

Major crypto assets are losing a lot of value and they are reaching lows that we saw before the pandemic. Volatility in the crypto market is not a new concept because these assets are known to be quite volatile; including major ones like Ether and Bitcoin.

Is LUNA a scam?

No, LUNA is not a scam. It is a legitimate governance token in the Terra ecosystem that happens to be the victim of circumstances.

It traded in all major exchanges too; until now that it has plummeted.

When investing in crypto or stablecoins, ensure that you vet the project. Bad projects have all kinds of problems, including insider trading.

What Happened to Luna?

To understand how big of a loss we are looking at here, consider that in April, Luna was trading at $116 (as of writing this, it trades for less than $1). Its market cap has dropped from over $40 billion to $641 million.

When the value started going down, naturally, the algorithm took measures to minimize the number of LUNA in the market. There were desperate attempts to achieve this, including offering investors 19.5% yield on stakes in the Anchor Protocol.

The UST token decoupled from the dollar earlier this month:

The Anchor Protocol allows people to invest their savings on the Terra blockchain to earn a high interest (no bank offers anything close to the 20% that Anchor provided at one point).

Before the crash, more than 70% of UST’s supply was deposited in Anchor.

Terra also has BTC reserves that are under the Luna Foundation Guard (LFG), a consortium whose job is to protect the peg. The LFG had about $1.5 billion in bitcoin reserves.

This was needed because if UST dipped below $1, bitcoin reserves would be sold and UST bought with the proceeds. Conversely, if UST went above $1, creators would sell UST until it goes back to $1.

What Went Wrong?

Problems began when the Anchor Protocol, which promised to pay a high interest for UST deposits, amended its rules to allow interests paid to be reduced.

Many UST investors, who were enticed by the high interest rate (20%) promised by Anchor, decided that it was not worth sticking around if they would be earning progressively less money for their stakes.

Therefore, they started leaving the Anchor Protocol in droves (some investors probably left because they saw the heightened activity and panicked).

Over $2 billion worth of UST was taken out and hundreds of millions of this was sold immediately.

There are two ways to dispose UST:

You can swap $1 UST for $1 LUNA, burning the UST in the process. When UST falls below $1, this is one way for people to make money because they can exchange it for $1 LUNA for a profit.
You can sell UST units on the stablecoin exchange, Curve Finance. If the value of a stablecoin falls below its peg, some traders head over to Curve’s liquidity pools and they trade the cheaper stablecoin for another that has maintained its value.

This graph shows a change in the supply of UST:

This chart shows the change in supply of LUNA:

As you can see in those diagrams, as users tried to drop UST, they burned it while at the same time creating more LUNA tokens. This diminished the value of LUNA because its supply increased drastically.

At one point, the value of LUNA fell so low, it was impossible to mint enough of it to compensate the UST traders who wanted out.

This exit route was not straightforward because there were technical challenges. For example, the network limits how much UST or LUNA can be burned or minted at a time.

Things slowed down and congested and exchanges began pausing withdrawals.

Over at Curve Finance, when UST went below $1, people started offloading it in favor of any other stable coin, including Tether’s USDT or Circle’s USDC.

Due to a sudden increase in the number of UST in the liquidity pool compared to the other stablecoins, there was a serious imbalance.

To correct the imbalance, Curve lowered the price of UST to tempt investors to go for it thus lowering its supply and pushing prices back up. The problem is, this time investors were not biting despite being offered a lucrative option. No one wanted to touch the cheap UST.

Consequently, the market capitalization of UST overtook LUNA’s, which meant that LUNA would no longer be able to do its job as a governance token.

The Luna Foundation Guard (LFG) dumped a ton of UST into the Curve pool to help the stablecoin find its peg. The Terra creators also allegedly began deploying the Bitcoin reserves to a market maker who was instructed to spend the Bitcoin when UST fell below the peg and vice versa.

UST momentarily recouped some of its value, going from $0.64 to $0.93. But this was short-lived because the exits quickly nullified the bailout.

On May 8, LUNA’s supply went up from 343 million to 32.3 billion three days later.

Why is this important?

Crypto investments have been wildly popular since 2020 because they were seen as a store of value during a period of uncertainty. Many people have made a lot of money trading and even buying and holding them.

And that makes the LUNA crash significant because of how bad it has been for investors. Some people had their portfolios and life savings wiped out as up to $15 billion in crypto value was lost.

Cases of depression and anxiety due to such heavy loses are on the rise because they lost a lot of money that they had hoped would help them out in the future.

On top of that, the damage has gone beyond the Terra platform because people who had invested in LUNA and UST must have sold off big parts of their crypto portfolio to recoup some of their losses, which would have the effect of pulling the entire market down.

Another concern this brings has to do with how stablecoins operate. The Terra platform was for an algorithmic stablecoin, which raises questions about the stability of these coins and their ability to even things out when things get rough.

Even stablecoins that are backed by assets or fiat currencies are not guaranteed stability.

There is also the question of dishonest practices. For example, New York’s attorney general accused tether of lying about how much it actually held in dollar reserves.

Analysts who suspect that this crash was caused by a cyber attack worry that what happened to UST and LUNA may spread to other stablecoins. This means that if malicious attackers have a template that works, they can use it to target other players.

All said and done, this crash attracted the attention of political leaders and regulators. There have been calls to regulate the market but they have often been rebuffed because one of the appealing things about the blockchain is its ability to decouple from centralized authority. However, authorities appear to be closing in with every incident like this that happens.

Conclusion

Stablecoins that are decentralized are the ideal for fans of De-Fi. They see Bitcoin, Ether, and other cryptocurrencies as too volatile to be used as a medium of exchange.

However, the crypto markets have faced a number of challenges this year. For example, they have been affected by high inflation and interest rate hikes by the Federal Reserve that also caused a sell-off in the stock markets. Although it may not be well understood, there seems to be a correlation between cryptocurrencies and stock market sentiment.

Panics in the market push prices down and that’s exactly what happened to LUNA and UST. In this case, investors could not offload the tokens fast enough despite efforts to lure them back in. This was partly because of technical restrictions in the market.

Ultimately, the mood in the crypto community was fear and that drove people to sell.

Will Terra LUNA recover from this rug pull?

As I write this, UST and LUNA have been delisted from major exchanges and there doesn’t seem to be a way back for Terra. There may be some traders who want to hang tight but it looks ever more likely that this is the end.

This should open our eyes to the fact that our investments in cryptocurrencies can vanish in thin air in a matter of days.

Before you leave

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David Fortune

David Fortune has been the editor NoBSIMReviews.com since 2019. He is an expert at writing content on stock advisory services, side hustles, reviewing online business opportunities and many more topics. You can learn more about David on our about us page.

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