LUNA - Understanding the Lunatic Drop 👇🧵

10 May 2022

Trying to find the explanation of what went SO wrong with Luna i found the best possible explanation here:

UST fell to a low of $0.66 while LUNA crashed to a low of $24.85 overnight.
Lessons learned from LUNA UST disastrous collapse 👇🧵


But let's assess what actually happened.

- UST deposits on Anchor fell 43% in a day (currently 6.7bn)
- UST getting massively shorted + sell-off on Curve
- LFG emptied out all its reserves to save the peg
- Rumours that Citadel engineered the attack

/ Lesson 1: Death Spiral

Illustrated perfectly by
@ZeMariaMacedo
, the design of LUNA UST is a giant positive feedback loop.

This was the "flywheel effect" that everyone's talking about but very few actually viewed it as a double edged sword.

A design that has a tendency to spiral out of control, even if it is to the upside, is a fundamental flaw. Most positive feedback loops are bad, be it in biology or engineering.

Don't get caught up in the buzzwords like "flywheel effect" esp when things seem rosy.


Lesson 2: Arbitrageurs can stop arb-ing

UST peg is maintained by:
- Arbitrage
-
@stablekwon
& LFG's deep pockets

If UST falls below $1 (e.g. $0.95), arbitrageurs buy UST for $0.95, redeem the UST and mint $1 worth of LUNA.

Profit = $0.05, UST supply falls, UST --> $1

But if LUNA is in a prolonged downturn, the risk of holding onto LUNA after minting is high.

The arb profit might get wiped after minting LUNA as LUNA price keeps dropping, hence arbitrageurs might abstain and choose to chill instead --> stabilization mechanism fails

Lesson 3: Over-reliance on Do Kwon & LFG

Crypto is built on the ethos of being independent of trusted third parties.

If UST relies on the aggressive, interventionist measures of centralized entities like Do Kwon & LFG, how is it scalable?

Imagine maintaining a peg by having the founder pump in capital each time shit goes south? Everything about Terra operates off the back of exogenous capital injection.

Even Anchor's 20% APY relies heavily on the yield reserve top ups instead of revenue earned from lending.

The idea that Terra is too big to fail is very dangerous and it's why many diehard LUNA maxis got burned today. It's a house of card built entirely on trust, in a supposedly trustless space.

Lesson 4: Cult Heroes

Cult heroes in crypto have the same ending. Daniele Sesta and Frog Nation. Andre Cronje and FFTM community.

Do Kwon is next... He is a great guy don't get me wrong, but never all-in your trust in a cult hero and invest on people

Lesson 5: Stablecoin Designs

Seems like pure-play algo stablecoins can't withstand the heat. Over-collateralized stablecoins are icky cuz they're like loans instead of currency and have a massive capital utilization problem.

A hybrid model might be it...
@fraxfinance

Lesson 6: LFG Reserves Transparency

LFG is transparent about the size of its reserves and you can track their wallets in real time.

Central banks usually avoid disclosing the size of their forex reserves e.g. Singapore or they release lagged data

Conclusion:

A lot of trust has been lost today. It really goes to show the importance of a sound, self-sustaining system beneath the veneer of marketing gimmicks.

Can UST and LUNA rise again? Definitely. But A LOT of work is needed to fix the fundamental design flaws.