Last week we took a deep dive in the Lunaverse where we discussed what the Terra blockchain was, how it works, what makes it unique, and some of the benefits of the ecosystem as a whole. This week we will take a closer look at the risks associated with the Terra Luna Ecosystem and what steps have been taken to mitigate those risks.
The mint/burn mechanism
To recap, the mint/burn mechanism within the Terra Ecosystem is something that is unique and has not been attempted at this scale before.
As the Terra Docs puts it, the mint/burn mechanism can be described as a process in which the UST stablecoin maintains its value equal to that of $1 USD by incentivizing arbitrageurs to maintain its peg.
This process looks like this: the burning of LUNA and the minting of UST will bring the price of UST down. The burning of UST and the minting of LUNA will bring the price of UST back up.
For example, if UST is trading at $1.05, arbitrageurs can burn $1 USD worth of LUNA to mint 1 UST and sell it on the open market for $1.05. In doing so, arbitrageurs profit 5 cents for every UST minted. On the other hand, If UST is trading at $0.95, arbitrageurs can burn 1 UST, and subsequently mint $1 USD worth of LUNA which they can sell on the open market for 1 USD, netting a profit of 5 cents.
Risks associated with the mint/burn mechanism
Oracle Manipulation Attacks
The first risk comes from the on-chain cap on the mint/burn mechanism. The purpose of the cap is to mitigate oracle manipulation attacks and frontrunning attacks which can abuse the mint/burn mechanism and cause UST to lose its peg. Oracles are a method of trustlessly sending price information directly to a smart contract. These prices are often provided by multiple reliable crypto exchanges but can be provided by Decentralized Exchanges too. If the oracle price is different from the current market price, this could cause instability. Using the DeFi lending and borrowing platform, Anchor Protocol as an example, if the oracle price of LUNA was being reported lower than the current market price, bLUNA used as collateral could be liquidated when it shouldn’t have. The current cap sits at $20m at 2% spreads and can easily be adjusted for market conditions, according to trading firm Jump. This cap is for on-chain mint/burns on the Terra blockchain only. It is important to note, on-chain liquidity should be slightly less than off-chain liquidity (liquidity on centralized exchanges) to prevent oracle attacks. This is why the $20m cap is used as a safeguard against oracle manipulation attacks.
The LUNA Price Crash
However, this cap can backfire as seen during the LUNA price crash on May 19th, 2021. Shortly after China banned crypto mining operations, crypto markets sold off significantly. The bearish news sent bitcoin down 30% from 43,000 USD to 30,000 USD.
The drawdown resulted in $700B USD being wiped out of the cryptomarkets within one day. LUNA suffered a price crash of 48% that day, and proceeded to fall another 52% over the next couple days as large amounts of bLUNA staked on Anchor Protocol got liquidated. During this mess, the price of UST fell to $0.85 because of a combination of 3 reasons.
- The on-chain cap of $20m was reached which forced the 2% spread to widen. This made mints and burns of LUNA and UST unprofitable. Since arbitrageurs would be minting/burning at a loss, this made it difficult to maintain UST’s peg by arbitraging. But it also prevented on-chain oracle manipulation attacks.
- The price of LUNA fell so quickly that by the time arbitrageurs bought UST, burned it, and minted LUNA, the price of LUNA had already fallen so much that they could not sell for a profit.
- bLUNA used as collateral on Anchor protocol got liquidated due to the sharp decline in LUNA prices. This caused a cascading spiral of liquidation events which sent LUNA down further. A Sharp decline in LUNA would mean less incentive to arbitrage LUNA/UST to maintain UST peg.
The depeggin of UST only lasted a few days. This is because UST/LUNA was arbitraged on centralized exchanges. Due to the latter, the risk of UST losing its peg over a sustained period of time is unlikely. In fact, there are rumors an entity with deep pockets has saved UST from losing its peg before by buying large amounts of UST on a centralized exchange. This propped up the oracle price of UST and incentivized arbitrageurs to continue utilizing the mint/burn mechanism to restore UST’s peg.
Preventing this risk
Since the crash in May 2021, steps have been taken to prevent this from happening again. The cap has been lifted to $100m. Centralized exchange volume has increasingly picked up, which allowed the cap to be lifted without risk of oracle manipulation attacks. The increase in market activity meant that LUNA and UST could withstand a higher threshold.
At the time of writing, the overall market capitalization of LUNA and UST has increased over 10 fold since May 2021. Furthermore, Anchor Protocol introduced partial liquidation which reduces sell pressure of bLUNA. A Tobin tax of 35 basis points could be changed during high volatility events to make staking LUNA more profitable. This would prevent stakers from selling their bLUNA because it would incentivize long term holding and would also act as a buffer against market volatility.
Net Outflows (LUNA/UST)
The other risk comes from UST and LUNA leaving the ecosystem entirely. Due to the UST/LUNA relationship, the market capitalization of both LUNA and UST should be looked at as if it were a whole.
At the time of writing, LUNA’s Mcap is $33 B and UST is $18 B USD. If the combined market capitalization of LUNA and UST were to shrink increasingly over time (possibly due to stablecoin regulations, reduction in Anchor yields, bear market), UST can be at risk of losing its peg and severely affect LUNA’s price.
If UST were to be sold for non UST/LUNA related assets, more LUNA would need to be minted to maintain UST’s peg. To maintain UST’s peg, inflation of LUNA would increase and whether staking rewards outpace inflation may or may not make it sensible to stake LUNA.
The result of this negative flywheel effect would be a continuing decrease in LUNA prices over time which would disincentivize stakers of LUNA, drop UST yields, and drive investors to platforms that offer better yield at reduced risk.
In other words, a contraction of UST’s supply has a very negative effect on the price of LUNA and UST yields, both of which contribute to even lower LUNA prices and lower UST yields.
Relation to Anchor Protocol
By analyzing the amount of LUNA being staked and the amount of UST that live on Anchor protocol, it is very convincing that UST yields and the recent increase in LUNA prices paired with an admirable staking rewards rate, are main factors that pull investors to the Terra Ecosystem. Since a large sum of deposits live on Anchor Protocol, it is important to associate Anchor’s risk with that of UST and LUNA.
At the time of writing, $13 B of a total $18 B UST lives on Anchor Protocol as deposits. $4.6 B USD worth of bLUNA is also being used as collateral too. If LUNA were to suffer high dilution due to minting LUNA to maintain UST’s peg, this can reduce the amount of borrowers on Anchor since money is lost on holding collateral (bLUNA price decline).
This would relate to less cash flows generated by Anchor which means less yields could be passed on to lenders. Sharp declines in LUNAs price could also cause mass liquidations on Anchor which would then make UST fall off peg by more.
However, some backstops have been created to prevent cascading liquidations.
Preventing this risk
Kujira is a project focusing on stability of Anchor’s liquidation mechanism to prevent a violent cascade of liquidations. Anchor has also introduced partial liquidations which helps absorb volatility.
However, in a black swan event it is still possible that UST/LUNA can fall victim to the same fate MakerDAO’s DAI faced during March 2020 ETH liquidations since the mint/burn mechanism relies on on-chain arbitrage which is not an efficient and reliable method.
The UST/LUNA relationship works well in a bull market because higher LUNA prices can support the demand of UST. However, in a worst case scenario, the dilution of LUNA due to a UST contraction can cause a negative feedback loop of downward spiraling LUNA prices.
Despite it all, as the Terra Luna Ecosystem matures and grows, I am more confident the Terraform Labs team can mitigate a lot of the risks mentioned above. For instance, the LUNA staking APY would increase in times of market volatility to incentivize market participants to keep their money on the Terra Protocol.
The Luna Foundation Guard (LFG) has also announced that they would be building up a $10 B USD treasury of bitcoin over the next several months. This should provide some stability and assurance to users as the Terra Ecosystem matures. This treasury could be used to stabilize UST in black swan like events.
Now that Terra is building a $10B bitcoin reserve, UST has been safer than ever before. The Luna Foundation Guard (LFG) will continue to accumulate Bitcoin and Avalanche over the following months to continue supplying the yield reserve on Anchor Protocol, a major contributor to Terra’s growth. Closely analyzing the TVL (total value locked), Anchor LTV (loan to value) ratio, UST yields, off-chain liquidity vs on-chain liquidity, and the combined market capitalization of both LUNA and UST will be pivotal in understanding the health of this ecosystem.
Although Terra brings unique innovation to stablecoins, it introduces new risks that are not fully battle tested in every market condition. Some might argue the May 2021 crash is a demonstration that in times of uncertainty there may be market forces that are uncontrollable, yet LUNA and UST are robust systems that allowed them to eventually recover.
At Finnt, we continually analyze risks of every protocol, blockchain, and/or decentralized application. Our plans are also very dynamic, meaning we take an approach where risk is diversified through different pools and we have the ability to quickly exit a pool if we feel the risks are beyond our threshold.