LUNA Market Update May 2022
What is the Terra Project?
The Terra project manages the LUNA token and the UST stablecoin. Theoretically, the UST stablecoin is pegged to a value of $1.00 USD by a mechanism that UST is always redeemable via a swap for $1.00 of the LUNA token. For example, if the LUNA token is trading at $50.00, 50 UST could be swapped for one LUNA token; conversely when 1 UST is minted, $1.00 USD of LUNA is burned (destroyed).
The system relies on a network of traders and arbitrageurs who seek to profit due to price anomalies who keep the peg for UST at nearly $1.00. This is what is known as an algorithmic stablecoin as opposed to a collateralized stablecoin. An algorithmic stablecoin operates by minting coins relative to other cryptocurrencies, which is an exciting proposition since the entire operation can exist on the blockchain and can be fully decentralized. Where a collateralized stablecoin such as Tether’s USDT requires the firm to administer the redemptions against their assets, which introduces more centralization into the system.
The danger is that an algorithmic stablecoin may have a tail-risk event such as the one LUNA experienced over the recent few days, which breaks the pegging mechanism.
Two days ago, the peg broke and UST closed at a value of $0.77 USD instead of the expected $1.00 USD. At the same time, the LUNA token dropped by 52% from $64 to $30. There are many explanations as to why this occurred, but the cryptocurrency market has been in a broad-based sell-off over the same period, which may have introduced concerns that this novel stabilization strategy will fail. Indeed, LUNA’s price has fallen from a high of around $116 USD to $1.05 USD at the time of this writing for a decline of 93%.
Figure 1: LUNA/USD through May 11, 2022 - Data from TradingView
Today on May 11, 2022 the UST token dropped even further intra-day to around $0.26, a 75% discount from its intended $1.00 price point before rebounding to $0.78, which has been the prevailing price for the past few days.
Figure 2: UST/USD through May 11, 2022 - Data from TradingView
What does this mean for UST and LUNA?
The current market cap for the LUNA token is $1,638,728,601 and 10,357,661,717 for the UST token, which makes the value of the outstanding UST is 6.3x the value of the LUNA market. This is sometimes referred to as an “overhang” in that there are more of the derivative token outstanding than there is market value to redeem it. If an investor were able to redeem all outstanding UST, there would not be enough LUNA available to redeem against.
Thus far, while some UST holders have been willing to exchange their tokens at a discounted price, many have not. Especially since the swap is for LUNA, which has had a 99% drawdown over the past few days. UST holders seem to be weighing their options. Because of the large drawdown in LUNA, it appears that investors are discounting the value of UST, perhaps because the primary value of UST is that it can be swapped for LUNA.
Investor behavior may come into play and LUNA die-hards may hold theirs in the hopes of a return to higher prices. The ecosystem becomes solvent again at around $6.70 LUNA, which is substantially higher than today’s price, but given the size of the arbitrage opportunity could be imagined. The most important question is: why aren’t arbitrageurs purchasing UST at a 25% discount and swapping it for LUNA that they could sell on the open market? Perhaps because the price of LUNA is declining so quickly they are uncertain that the 25% arbitrage opportunity is lower than the risk of holding LUNA for a few minutes – a dire conclusion if true.
Figure 3: Three Month UST Market Capitalization - Data from CoinMarketCap
Figure 4: Three Month LUNA Market Capitalization - Data from CoinMarketCap
It is always important to understand the mechanics of assets investors are purchasing and while Decentralized Finance is a promising technology, there will be many false starts and few projects will survive. These tail risk events are not new to fans of market history who remember when George Soros and other hedge fund managers were able to de-peg the Great Britain Pound or when oil futures fell below zero in March of 2020.
The popular notion that high-yield stablecoins are riskless is rapidly fading – as it should. Perhaps the best comparison in the traditional financial market is to high-yield debt, where the yield is understood to be a risk premium. Allocators must recognize the difference between risk premium and free money so they can develop an investment strategy that works even when tail-risk events occur.
- Terra Money: Stability and Adoption. Evan Kereiakes, Do Kwon, Marco Di Maggio, Nicholas Platias. April 2019
- About the Terra Protocol
- CoinMarketCap: Today's Cryptocurrency Prices by Market Cap
- Forbes Flashback: How George Soros Broke The British Pound And Why Hedge Funds Probably Can't Crack The Euro
- Oil Futures Go Negative in Historic Rout
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