The Crypto Version of the Mortgage Crisis: Fully Understanding the Collapse of LUNA and Terra (UST)

Terra was one type of stablecoin.

A stablecoin is a token that maintains price stability by being pegged to real-world currencies or assets.

Depending on what backs it as collateral, stablecoins can be categorized as follows:

1. Fiat-backed

You deposit fiat currency and issue tokens in an equivalent amount.

2. Crypto-backed

You deposit crypto assets and issue tokens equal to the value of those assets. Typically, highly trusted cryptocurrencies like Bitcoin (BTC) and Ethereum (ETH) are used.

3. Commodity-backed

Backed by commodities such as gold or silver.

4. Non-collateralized

The price is maintained by adjusting supply and demand.

Terra (UST), the most controversial case recently, belongs to the category of coins that maintain their price based on controlling the supply and demand of LUNA (type 4).

UST is supposed to stay at $1, so how does adjusting LUNA’s supply and demand keep it at 1 dollar?

The key is that you can swap between LUNA and UST by burning tokens.

a. If the price of 1 UST is higher than 1 dollar

b. Users burn 1 dollar worth of LUNA and swap it for 1 UST.

c. They sell the UST and lock in a profit.

d. The supply of UST increases.

e. The price of UST falls (until when? Until it drops to 1 dollar and the arbitrage opportunity disappears).

Conversely,

a. If the price of 1 UST is lower than 1 dollar

b. Users burn 1 UST and swap it for 1 dollar worth of LUNA.

c. They sell LUNA and lock in a profit.

d. The demand for UST increases.

e. The price of UST rises (until when? Until it climbs back to 1 dollar and the arbitrage opportunity disappears).

Through this mechanism, the changes in supply and demand keep 1 UST anchored at 1 dollar.

So why did the peg break?

To understand that, we first need to look at Anchor Protocol.

In short, Anchor Protocol is a deposit protocol that offers suppliers who deposit UST an annual yield of 20% (APY).

Since the terminology may feel unfamiliar, from here on we’ll just call Anchor Protocol Anchor Bank.

Let’s say Mr. Kim buys UST with dollars and deposits it at Anchor Bank.

Then Anchor Bank pays Mr. Kim 20% per year in interest, paid out in UST.

Now Anchor Bank needs to lend out the UST it received from Mr. Kim. What does Mr. Lee need to do if he wants to borrow from Anchor Bank?

A. Deposit LUNA or ETH and receive bLUNA or bETH in return

The “b” stands for “bonded” and represents a token that proves the asset is locked up as collateral.

B. Use bLUNA as collateral to borrow UST

If Mr. Lee then posts this bLUNA as collateral, he can borrow UST up to 60% of the collateral value.

Why did Mr. Lee want a loan in the first place?

C. Earn ANC rewards using UST

Mr. Lee can use the borrowed UST to earn ANC, the native token of Anchor Bank, as a reward.

In summary, for Mr. Lee to receive ANC rewards, he needs UST; to get UST he needs bLUNA; and to obtain bLUNA he needs LUNA.

Meanwhile, the person who connects UST to cash (that is, Mr. Kim) receives 20% interest per year in UST.

This protocol worked because

the rewards paid to Mr. Lee in ANC were larger than the loan interest he had to pay to Anchor Bank on his UST loan, allowing the system to sustain itself.

But what happens if someone dumps a huge amount of UST on the market?

The supply of UST surges, and its price falls.

At first, that’s fine. People can burn UST to swap it for LUNA, and the price of UST should rise again.

Then UST stays below 1 dollar for a longer period of time.

The longer UST trades below 1 dollar, the less it functions as a stablecoin, and the more anxious Mr. Lee becomes.

Mr. Lee borrowed UST using bLUNA as collateral. If the value of UST falls, others will swap UST for LUNA and sell it (increasing supply), which pushes down the price of LUNA.

Because LUNA is intertwined with bLUNA and UST, a drop in the value of LUNA brings Mr. Lee to the brink of liquidation.

Facing imminent liquidation, Mr. Lee runs for the exit. Even if Mr. Lee flees, Anchor Bank still has to honor the 20% yield promised to Mr. Kim.

But Anchor Bank can only keep paying Mr. Kim that yield if there are many borrowers like Mr. Lee taking out UST loans.

As the number of borrowers shrinks, Anchor Bank has no choice but to cut ANC rewards. That drives even more borrowers away. Yet Anchor Bank still owes Mr. Kim a 20% yield…

This vicious cycle eventually makes ANC rewards unattractive to everyone.

In other words, there are effectively no more people who want to borrow.

With fewer and fewer Mr. Lees paying UST loan interest, Anchor Bank finds it increasingly difficult to keep guaranteeing Mr. Kim a 20% yield.

So Anchor Bank starts covering Mr. Kim’s yield using its own reserves—by selling the Bitcoin it holds.

As Anchor Bank’s reserves dwindle, it ultimately concludes that ensuring UST can hold its 1 dollar peg is more important than guaranteeing Mr. Kim’s yield.

Anchor Bank tries to defend the peg by selling its reserves (Bitcoin), but UST still fails to hold 1 dollar.

At that point, every anxious investor starts pulling out of LUNA and UST, and prices collapse.

Looking back at the era of the gold standard, when the U.S. government exchanged 1 ounce of gold for 35 dollars, the Nixon shock occurred because there were too many dollars relative to the available gold.

The U.S. then made the shocking announcement that it would no longer convert dollars into gold. Gold prices then soared relative to the dollar. In other words, the dollar’s value plunged relative to gold.

That was essentially a broken promise between the dollar and gold.

You can think of UST in a similar way. It promised that if you handed over 1 UST, you would receive 1 dollar. But oversupply led to depegging, and the problem became unsolvable—in other words, you could no longer get 1 dollar for 1 UST.

The dollar’s value shot up relative to UST, and conversely, UST’s value plunged relative to the dollar.

The combination of “rising demand for LUNA to earn ANC rewards” and “burning LUNA in the process of swapping it for UST (reducing supply)”

had previously created a structure that pushed up the value of LUNA.

But that is no longer the case. Because of the drop in UST’s price, the supply of LUNA has become absolutely massive.

To restore the peg, reserves would need to be used to bring UST back to 1 dollar, but that is no longer possible.

The fallout from LUNA and UST was substantial. It stoked fear and even spilled over into Tether (USDT).

Tether is the largest stablecoin by market cap and falls into the fiat-backed category (type 1).

Strictly speaking, it’s not a bank that exchanges 1 USDT for 1 dollar, but Tether Holdings itself.

And the USDT traded on exchanges is USDT that those exchanges have already purchased in advance from Tether Holdings,

so traders are not required to go through Know Your Customer (KYC) checks or Anti-Money Laundering (AML) procedures with Tether Holdings directly.

Ultimately, this is a matter of trust, so skepticism is understandable. But UST’s collapse is unlikely to directly topple USDT.

UST’s ability to maintain its price relied on USDT and USDC, yet the structural weaknesses that doomed UST are not present in USDT, which has secured liquidity through major exchanges.

As of now, Tether Holdings’ reserves consist of

83.74% cash, cash equivalents, short-term deposits, and commercial paper,

4.61% corporate bonds, funds, and precious metals,

5.27% secured loans,

and 6.38% other investments, including cryptocurrencies.

Within cash, cash equivalents, short-term deposits, and commercial paper,

52.41% is in Treasury bills,

and 36.68% is in commercial paper and certificates of deposit.

It is indeed concerning that commercial paper accounts for 30.71% of total reserves.

If Tether were to collapse, the major exchanges tied to it would be in serious trouble, and that could directly trigger a broader collapse of the crypto market.

However, such a scenario is still considered unlikely at this point—similar in probability to a full-blown bank run—so the prevailing view is that it is not yet something to panic about.