Reopened “Asia Financial Crisis” in Crypto — Luna and UST event
After Luna has crashed and become dust and ashes for nearly a month, it has set an indelible milestone in crypto history and taught all of us a lesson — being aware of anything unknown and ignored. History repeats itself, Luna incident seems like another classic Ponzi scheme in the financial industry to me, but this time happened and was covered by crypto and blockchain technology, which is ironic that they should play a role as a security gatekeeper. After taking a looks at the sequence of Luna events and arbitrage mechanism under the hood, honestly saying, the damage is not that unpredictable and has been kept mentioned before the incident in the community with its
- negative yield on Anchor banking, and
- UST backed by Luna whose value highly built on the Terra Luna chain from POS staking, governance & gas fee, requiring certain amount of activities in the system.
Since storytelling is more straightforward and understandable to realize the ins and outs of Luna from a comprehensive view with both sharing similar factors and circumstances, let me introduce one of the famous and recent financial crises at the end of 1990 — the Asia Financial Crisis.
Let’s jump to the ending of the story beforehand, the outcome was a sequence of depreciation of currency triggered by Thailand’s policy of giving up the fixed exchange rate, leading to the slumped stock market and massive withdrawal escaping from Asia. While most people attribute the cause to depressed investors and losing faith on market, it’s simply the last straw being a foreseeable outcome rather than a reason.
We will depict from the scratch first. Lots of investors are looking forward to the development of Asia especially Southeast Asia in the 1990s for their subsequent high GDP growth as most developing countries adopt the export-led strategy to stimulate the export by the means of 1) subsidies, 2) favorable high-interest rates, 3) fixed exchange rate to enjoy competitive price. Besides, this seems like an appealing and reasonable investment as the US was in the expansion then by president Reagan along with Reaganomics policy by the means of liberating government control.
As the result, a large number of funds and investments flow into the Asia market; however, when equity exceeds its substantial value, which gives rise to either negative yield or unsustainable business model and financial performance, it is undoubtedly a bubble. One of the famous economists Krugman mentioned the alert in 1994 and pointed out most of its high GDP was sourced from investment capital inflow rather than the shares by exporting the goods. What’s worse, everything deteriorated when the government still tried to “anchor” the exchange rate to USD, accumulating massive USD-denominated external debt to ”withstand the pressure of appreciation.
While the market is never good as always, please keep in mind that the market is dynamic and everything could happen all of a sudden, lack of foreign reserves with poor export performance and giant credit loans lives a high probability of leading to the exposure to debt default — failing to pay off the debt — when cash is washing off and transferred to where yield higher attractive interest rate, coincidently, US has started to raise the interest rate to combat inflation then, thereby making those loans denominated in USD spike and starting bankrupt among the countries and enterprises.
Taking a little break, let’s do a quick recap by extracting and listing out some influential but neglected factors:
- Fixed exchange rates
→ remain fixed exchange rate to stimulate export
2. Trade deficit
→ borrowed funds were in vain on trading performance
3. Accumulated loans
→ debt from depositor and investment
// note: The increasing amount of loans doesn’t always represent worse financial performance, sometimes it even means business last a health cycle unless your equity is profitable and affordable.
Jumping into our main role — Luna — and doing a comparison, it seems like Luna shoot himself in the foot by repeating the same mistakes
In Luna scenario:
1. Fixed exchange rate
As you know, UST is an algorithmic Stablecoin of Luna Labs, trying to peg to USD under its unique arbitrage mechanism. The brief concept depends on a minting/ burning mechanism to balance the quantity of both assets in the pool, pushing the price back to $1. However, the model seems rather sustainable and flawless in a limited amount of trading, it requires some premises honestly saying.
Everything works smoothly if the current price is above the peg because it is easier to make something devalued as Luna can mint the UST to enlarge the amount of UST when Luna is appreciated, but vice not versa. The mechanism is attached to investors being rational and withstanding the expectation that price will come back somewhen in near future, for example, let’s assume the current LUNA price, LUNA/ USD = LUNA/ UST = 100. In theory, when UST is below $1 at 0.8$, we could buy 100 UST at the cost of $80 on the market, then exchange for 1 LUNA for $100, selling on the market to earn a $20 profit. But when huge trades come in to pressure on the price significantly, the beliefs of either
- UST price tagging at $1
- or Luna’s price being unchanged at $100
were broken, it thereby expands the quantity of Luna and devaluates it which squeezes the arbitrage space — $20 zone in the example — if
- someone can buy at a less costly price like 0.75$ and sell Luna at a competitive price below $100
- or Luna dropped by over 20% in the above example
Extendedly, we could use Game Theory way of thinking to make the explanation much more understandable and solid. Let’s talk desired case first,
- when market is quiet without disturbance, long position, who think something is valuable and true value is over current price, and short position, who think something is overvalued and true value is below current price, are nip and tuck, leading to price being dynamically unchanged and pegged to willing price with a little and acceptable fluctuations.
- while in second example, in serious bear market and negative yield performance or limited revenue of Luna, unquestionably short positions are dominant over long positions, making no one believing in recover, keeping price falling for long position not existing anymore.
Moreover, the cost of remaining the price is increasing when the USD is appreciated during FED carries out the “interest rate hike” policy. In our arbitrage model, we highly depend on Luan’s value to support the price, whereas it’s not enough against the imbalance market cap between UST and Luna, meaning Luna is incapable of paying most of the accumulated debts. Briefly saying, we are using descending Luna to amid the wound caused by ascending USD.
2. Trade deficit:
While it is a bit imperceptible talking in “trade deficit” terms when it comes to the crypto world, changing the definition to “generated revenue” which leverages on borrowed funds will be more sensible. In the Luna chain, the usual revenue is collected by 1.) transaction fee 2.) POS staking 3.) governance mechanism, as you could reckon and infer, the above three revenue are all highly dependent and bet on “activities on Luna chain”. As the result, if Luna still hasn’t yielded enough profit thereby pouring the value to Luna’s price, it will lose the ability to recover the UST.
3. Accumulated loans:
such a high deposit rate like 20% is a kind of creeping cancer when investment ( Luna ) is still in a faint stage and developing. Same reason scenario from Asia financial crisis, a huge amount of borrowed funds from current depositors without enough loan fees borrowing to lenders to carry on loan system, Anchor playing a role as negative yield bank.
Arbitrage model is not useless as it shows, however, it opens up a innovative path to making crypto world decentralized and efficient. What has been ignored is lacking some emergency measures to avoid attacks or pressures from large scaled trading, which is the reason as well why DAI could withstand against Bear market and investors panics. I might do some analysis and smart contract reference to its smart contract design in the future, explaining why over-collateral backed stable-coin is much more secure.
That’s all the analysis and sharing. Hope you enjoy it !
:)
