What happened to LUNA?
What are algorithmic stable coins? Algorithmic stablecoins typically rely on two tokens – one stablecoin and another cryptocurrency that backs the stablecoins – and so the algorithm (or the smart contact) regulates the relationship between the two. To prevent the price of a stablecoin depegging – moving away from $1 – while subject to market conditions, algorithms regulate supply and demand. When there’s too much demand for an asset but little supply of it, the price of that asset goes up – and vice versa.
In the case of TERRA LUNA, Terra is the blockchain that maintains the supply of two cryptocurrencies: LUNA and UST. They are traded and priced online in places like Binance, Curve and many others. If the price of LUNA is $0.25, then a trader can “burn” (or destroy) one UST to “mint” (or create) four LUNA on the Terra Station. Conversely, if the price of LUNA is $3, a trader can mint one UST by burning 1/3 LUNA.
After remaining close to 1 US Dollar since its inception in November 2020, the Terra UST lost more than 75 percent of its value in the two weeks of May 9th to May 15th, 2022, leading to a price collapse of the underlying LUNA token of more than 99.9 percent.
What happened? The redemption of UST meant that a lot more LUNA had been minted and was in circulation: The supply had been hyperinflated by about 8 times from 0.4 billion on May 10 to 32.0 billion on May 12. The price of LUNA tanked further from $31 to $0.01, and LUNA’s peg was abandoned. Since then, UST and LUNA have been removed from major exchanges.
Haralg Uhlig develops a novel model which shows how a crash such as the crash of the Terra-Luna system can unfold gradually. His novel approach leads to findings that could shed light to market crashes. In particular, Uhlig shows that market participants hesitate to anticipate the final outcome, because they continue to believe in the possibility that things would return to normal.
This raises the deeper question whether indeed full runs are rare or whether agents are simply overly optimistic, once a crash is on its way. I propose that Understanding these forces more deeply is of importance for policy interventions in market crashes, and worthy of further exploration.
Why Stablecoins Fail: An Economist’s Post-Mortem on Terra
Author: Russell Wong
From: Federal Reserve Board
A Luna-tic Stablecoin Crash
Author: Harald Uhlig
From: University of Chicago
