The biggest debate raging around the crypto world is whether or not Luna UST is one gigantic Ponzi. people are so heated about this that they’ve bet each other millions of dollars on the eventual fate of Luna and UST. But why should we care? Well, if you hold Luna or UST, you absolutely should care because if the critics are right, those coins could crash to zero just like other algorithmic stable coins have done in the past. Even if you don’t hold these coins it could still affect you because several other D5 protocols have started to integrate with both the Luna and UST. if they crash it could cause a wide-reaching domino effect. that’s why I want to explore the best parts of this Ponzi debate and break it all down for you.
Starting from the top terra is the overarching project here and its goal is to introduce decentralized algorithmic stable coins to the world. Now, there’s a lot of stuff going on in the terra world but in terms of this Ponzi debate there’s really three relevant pieces: Luna, UST, and Anchor.
Let’s start at the absolute core of the system: Luna/UST and discuss how they relate to each other. UST is a stable coin that aims to maintain a one-dollar peg but what makes it special is that it’s not backed by anything. In other words, there’s no collateral behind it. Other stable coins like DAI or USDC have some sort of collateral backing it whether it’s US dollars or crypto coins like ether. But UST instead relies on arbitrage and market incentives to maintain its peg. It does so by working with Luna. which is also the native token of the terra ecosystem.
Here’s how they work together to keep UST close to one dollar. They have this on-chain swap feature where you can exchange Luna for UST and vice versa at a fixed rate. More specifically you can burn one dollar worth of Luna and the protocol mints one UST for you.
You can also go in reverse and burn one UST and the protocol mints one dollar worth of Luna for you. This is all done on-chain so you get this deal regardless of UST’s price on the off-chain markets, such as other exchanges.
This is key right here because you have two options. If you want UST, you can buy it on outside exchanges or you can do this minting and burning mechanism. The option that people use depends on what is more economical for them because sometimes UST is over one dollar on exchanges and other times it’s under one dollar.
You may be wondering why that even happens. Well, it comes down to demand for UST fluctuating. Let’s say you want to use some Dapps in the terra ecosystem. In which case you need UST so you trade your tether for it. That buying pressure drives up the price of UST so it could go over one dollar. On the other hand, if you have a lot of UST but you want other stable coins for whatever reason, then that selling pressure drops its price potentially below one dollar. When either case happens terra’s system relies on arbitragers to bring the price of UST back to one dollar.
Let’s walk through each case step by step because that’s going to help us better understand where the danger is.
Scenario one is where UST is over one dollar. let’s just say it’s trading for $1.05 on outside exchanges. Here’s how you can make a profit as an arbitrager. Let’s say Luna is $100 and you have one whole Luna so you go to their on-chain swap and burn it for $100 UST, then you go to an off-chain exchange and sell your UST for $105 worth of some other staple coin because remember UST is trading at $1.05 right now and you have a hundred of them. Boom! that’s $5 worth of low risk profit for you. Now, you and other people are going to do that over and over until your selling pressure drives UST back down to one dollar. That’s how the system works. Pretty simple and elegant, right?
One other piece to note is that this arbitrage process increases the supply of UST and decreases the supply of Luna because you are burning Luna and the system mints new UST for you.
On the flip side we have scenario 2 where UST is under one dollar let’s say at 95 cents. In that case you can do similar arbitrage where you buy UST and burn it for one dollar worth of Luna and then go sell that Luna on outside exchanges to lock in your profit. By doing this you drive up the price of UST back to one dollar because you and other arbitragers are buying UST first before burning it. For Luna this process also decreases the supply of UST and increases the supply of Luna. And this is why UST is an algo stable coin because the system is dynamically adjusting the supply of UST and Luna and relying on economic incentives to bring back the price of UST to its desired peg. So, Luna’s role is to basically absorb the price volatility of UST.
This is all pretty straightforward though right, so where’s the problem?
Algo stable coins have historically been very fragile and many of them have permanently lost their pegs. Just check out empty set dollar or ample force or basis cash. when you saw those charts you’d probably think there’s some regular crypto coin but no, those are actually supposed to be stable around one dollar. They are pretty much worthless right now because their whole reason for existence is to stay stable and they couldn’t even do that properly.
Perhaps the most infamous algo stable coin failure was the iron finance fiasco. I’m not going to go too deep but essentially this was another algo stable coin project, where Iron was like UST and Titan was like Luna now. They were humming along fine, and the price of titan was rocketing while demand for iron was soaring. But on one fateful day it all came crashing down. Their stabilizing process stopped working properly when the price of Titan felt too fast and the protocol printed more and more Titan to try to compensate, that dynamic led to a death spiral where the Iron stable coin was unable to regain its peg, and titan crashed from around 60 to zero dollars in the span of a few hours. This wrecked a ton of Titan holders, most notably Mark Cuban who called for more stable coin regulation after. This pissing off a lot of people in crypto. But just because those algo staple coins failed in the past doesn’t mean UST will because there’s a lot of differences after all.
Let’s zoom into UST and spell out why people think it will fail.
Remember that scenario 2 that I outlined earlier. That’s where UST is under one dollar on off chain markets. If there’s a lot of selling pressure for UST and it’s hard to bring it back to one dollar. Then there’s a big problem because people will start doing that arbitrage process where they buy UST burn it to mint new Luna and then sell that Luna on exchanges for profit. But by doing so they are putting immense cell pressure on the Luna order books out there because remember an order book is just the resting limit orders for some particular asset, so if the order book is thin then that means there’s not a lot of buy orders on there. And all this newly minted Luna getting dumped will clear the order book and crash the price hard.
This scenario is the whole basis for the infamous death spiral which wrecked other algo staple coins before. It’s where the price of Luna is dropping fast, and people lose faith that USTs peg can be successfully defended. So, they burn their UST in droves to mint new Luna that they can sell. But by doing so they’re inflating the supply of Luna and increasing the selling volume because remember, for each UST you get one dollar worth of Luna. But as Luna decreases in price you get more Luna in return for each UST that you burn, so that means more Luna are getting dumped on off-chain markets. And on and on the cycle goes until we’re left with hyperinflation for Luna and the price is worth zero.
Now that definitely sounds scary no lie but there’s a lot of detail here that we’re missing. For example, the price of Luna is actually super important to the stability of the system because if Luna drops too low, then its market cap could be less than the market cap of UST. But why is that an issue? Because the system promises us that its on-chain swap will always give us one dollar worth of Luna for every one UST that we burn. But if Luna’s market cap is lower than UST’s then burning every UST out there wouldn’t get us the equivalent dollar worth of Luna that were promised.
So, if people see Luna’s market cap dropping lower and lower then that could lead to the loss of confidence that I mentioned earlier. Another aspect that’s super important is how much liquidity there is on chain with a swap feature versus off chain on exchanges. Ideally, we want the on-chain liquidity to be slightly less than the off-chain liquidity. This means more liquidity for Luna and UST on exchanges like Binance and uniswap compared to the on-chain swap because remember if outside order books are too thin, then the normal arbitrage selling would affect Luna’s price too much and that could lead to the death spiral.
At the moment there is a healthy amount of off-chain liquidity so I’m not too worried about this. But what if governments come in and start putting more restrictions on stable coins? The head of the SEC did call stable coins poker chips after all. If they crack down on stable coins such as UST then centralized exchanges would be forced to de-list them, and that could create the dangerous imbalance that I was talking about.
But even besides all this discussion about market caps and liquidity we could ask why UST would even be under one dollar for an extended period of time. There are several possible reasons, maybe investors feel uncertain about it for whatever reason, or maybe they want to use some other d5 protocols that don’t accept UST, or maybe the overall growth of terra ecosystem just stalls or decreases. In which case the current supply of UST is more than enough, and people don’t need to buy or mint extra.
All of these scenarios could lead to more selling pressure for UST which decreases its price. That’s why it’s super important for UST and Luna to have multiple sources of demand because if they each only have one real source of demand then the system is very fragile. On the other hand, if there’s a bunch of different places for people to use UST and if there’s a ton of different utility for Luna. Then the system should be able to withstand more shocks.
Now just when you thought you’re starting to understand this whole system. I’m going to throw you a curveball and add another layer on top.
All our discussion about Luna and UST so far has ignored Anchor protocol which is another key piece in this whole Ponzi debate. Anchor is the main lending slash borrowing protocol for the terra ecosystem, but they stand out by offering roughly 20 yields on your UST which is among the highest that you can find in all of crypto as you can imagine. That’s driving a lot of demand for UST and roughly 70 of all UST in circulation is sitting in Anchor collecting that sweet yield.
But there’s two sides to this because we also have borrowers who deposit collateral such as bond and Luna. In order to borrow more UST, now borrowers do have to pay interest on their loan but they’re essentially getting paid to borrow because Anchor protocol rewards them in the form of Anchor tokens. And the amounts that they get is more than what they pay in interest. That’s pretty crazy and we don’t usually see people getting paid to borrow in the defy space this makes Anchor’s system pretty Ponzi-like.
Right now, given that they’re minting their own tokens to incentivize borrowing. But there’s another problem here because the protocol gives out 20 yield regardless of what’s going on with the borrowers. If the protocol is to sustain itself. Then the math has to balance out.
The cost of Anchor is simply all the UST deposited by lenders multiplied by the 20 yield that they are promised. It’s called cost because that’s how much the Anchor protocol has to pay out. On the other hand, the revenue of Anchor comes from two sources. It comes from A) the interest that borrowers are paying and, B) it comes from the staking rewards generated by all the bonded Luna and bonded ether that was deposited as collateral.
Anchor revenue equals loans taken out multiplied by the interest rate plus the total collateral times the staking yield. If revenue is greater than cost, then Anchor is generating a profit and that gets put into their yield reserve. But if revenue is less than cost then they have to dip into the yield reserve to give out that 20 yield.
That’s actually the case right now. There are way more lenders than borrowers, so the yield reserve is getting drained fast. In fact, the team has had to top it off two separate times in order to maintain their 20 offers.
At the moment the team is subsidizing this high rate as a growth tactic but the key question here is what happens when that stops. Will people still want to use Anchor when its yields are lower, or will they sell their UST and go elsewhere thus potentially triggering that problematic scenario that I mentioned earlier.
Another breaking point could come from the cascading liquidations that Anchor could cause because people use Anchor to take out loans. They deposit b Luna to get more UST and they use that to buy more Luna. They do that process over and over to get more leverage on their initial position. This is amazing when the price of Luna is going up, but the issue is when the price of Luna drops. If it drops too far too fast, some positions make it liquidated, and the end result of the liquidation is that their collateral or b Luna. In this case is bought by a third party and then sold on exchanges to lock in profits. This selling drops the price of Luna further causing even more liquidations to happen.
These examples are not just hypotheticals. Anchor has actually caused UST to lose its peg twice in history. First time was May of 2021 when all of crypto was crashing due to Elon and China FUD, but Luna felt especially hard because of cascading liquidations and that caused UST to lose its peg as well.
The second time was in January of 2022 when a key member of the abracadabra money project was outed as the former co-founder of Quadraga exchange. The shady Canadian exchange where one of the founders supposedly died and disappeared with 250 million dollars of customer funds.
but what does that have to do with Anchor? Abracadabra created a strategy called d-gen box where people could use UST to borrow another stable coin called $MIM, and then use that to borrow more UST and over and over until their position was earning more than 100 APY so essentially it was designed to help people milk as much yield out of Anchor as possible. But when that big news dropped about the shady co-founder. People lost confidence in the $MIM stable coin and because of how closely tied it was to UST, both stable coins lost their peg for a bit. Now, both times the peg did recover but rumor is that the terror team had to step in and manually intervene.
So, what I’m wondering is what if the system gets so big that one day even the Luna team does not have enough ammo to defend the peg. Will we ever get to that point? well not if we ask the lunatics (that’s the name for Luna supporters by the way). They would say chill out Luna and UST will be a-okay because, first of all UST is much different from those algo staple coins that failed. It actually has a legit blockchain and ecosystem surrounding it and Luna has diverse utilities such as paying for gas fees staking as a validator and more. So the value is only going to increase as the terra ecosystem grows, and as other Dapps adopt them as well furthermore.
The team has made several changes to both Anchor and the core swap mechanism to make them stronger. Like for Anchor their yield reserve was just topped off with 450 million dollars that should last quite a while if demand stays roughly the same. They’re also going to support more types of collateral for Anchor borrowers which could incentivize more borrowing and that helps with its sustainability. On the Luna side they upped their daily swap limits from 20 million dollars to 100 million dollars. The limit there is to prevent whales from manipulating the system but if the limit is too low that prevents arbitrage from doing their thing, so this move gave arbitragers more slack which should help in times of high volatility for UST.
The team even raised a billion-dollar bitcoin fund that will be reserved for defending the UST peg. This is a genius idea because BTC is arguably less dependent on anything within the terror ecosystem so it’s a much better asset to use for this peg defense than Luna, UST, or Anchor tokens.
For example, now these are just some of the arguments in defense of Luna UST but as you can see lunatics are supremely confident that the system will survive and thrive. That’s why their CEO Do Kwan did not flinch at all when he bet 11 million dollars on twitter that Luna would sustain over the next year.
If you ask me, I see merit to both sides.
I’m definitely concerned that the system is fragile in multiple places, and I think critics are right. To point out that early versions of the system were Ponzi-like but what I think they’re missing is that the team has actively shored up defenses and tweaked different levers to improve their resilience. So, while its early form may have indeed been a Ponzi I think it’s evolving towards a much different state that could actually be sustainable.
Either way I recommend all investors to proceed with caution just because it has survived thus far doesn’t mean it can’t come crashing down all of a sudden.