Market deep dive: Crypto market continues downward streak with Terra LUNA crash

This week in a nutshell: the market continued to crash, and any rebound was quickly sold off. US inflation figures for April came in higher than expected, making it harder for the FED not to push the US economy into recession with aggressive rate hiking to fight inflation.

As of writing, BTC$ is trading 16.2% lower at 30.4k over the past 7 days, and ETH$ is 23.4% lower at 2.1k.

Also the stock markets crashed, with the NASDAQ down 6.4% since last Friday’s close.

No doubt, the biggest event for any crypto investor (and maybe even for some more traditional market participants) was the de-peg of the UST. The by far largest algorithmic stablecoin is currently trading at 10 cents. LUNA is now worth close to zero, which equals a loss in market cap of more than 20bn$ within only a few days.

The idea behind UST is (or was) to have a stablecoin that was not backed by a centralised entity, but rather a mechanism that assures that the peg to the USD would hold. The mechanism was meant to guarantee that whenever UST was trading below 1 USD, an arbitrage would be possible, since 1 UST could be swapped for 1 USD worth of LUNA, and then be exchanged for 1 USD (and vice versa in the event that UST should trade above 1 USD).

On top of that, the protocol (mostly) guaranteed a fixed return of 19% p.a. for investors willing to lend out their UST.

Sound too good to be true? Then it probably is.

But to be fair, lending rates for USD in the crypto market are much higher than in traditional finance because there is (especially in times of rising markets), a large scarcity of USD in the crypto world. A regulatory wall that prevents money from flow into crypto easily can explain different lending rates for the same risk profile. However, the anchor protocol guaranteed a fixed lending rate for UST regardless of the fluctuation in the borrowing rate. This first big flaw made a yield reserve necessary, which increased when the borrowing rate was higher than the lending rate and vice versa. In the last few weeks, this yield reserve dropped massively, and the Luna Foundation (LFG) had to inject additional capital into the reserve. However, there was the possibility that the fixed lending rate would be lowered, so this alone cannot explain the implosion of UST.

The bigger flaw was a much simpler one. The algorithm that guaranteed the peg had one important condition: the market value of the reserve asset, namely LUNA, needed to be larger or equal to the outstanding UST notional. As there is no guarantee that a cryptocurrency holds a certain value, the algorithm cannot guarantee the peg. Especially when markets are falling.

Admittedly, this explanation leaves out many details about how UST and the anchor protocol were set up, and how the Luna Foundation tried to make it safer by adding bitcoin as a reserve currency. There are also rumours of a coordinated attack that served to trigger the de-peg. But in the end, all of this is irrelevant: a true stablecoin needs to be able to hold its peg, no matter what the market conditions are.

The shock waves that the failure of UST sent through the crypto markets were intense. Hopefully, harsh regulation as a result of this can be avoided, and hopefully there is a lesson learned by the entire crypto community: simple market mechanisms that are known in traditional finance for over hundreds of years also apply to the crypto market and cannot be outsmarted.

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