Do Kwon Details Recovery Plan, As LUNA’s Struggle Continues

Do Kwon, the founder of Terra, has outlined a roadmap to recover the project’s ecosystem after LUNA crashed 99% from its all-time high to below $1 and TerraUSD (UST) fell out of its USD peg.

Kwon shared with his 532K Twitter followers that he plans to work with the Terra community to “weather the crisis” and bring it back to form.

Terra’s native token LUNA fell all the way down to $0.69, over 99% down from its all-time high of $119 after Terra’s UST stablecoin struggled to hold its peg to the US dollar. LUNA currently trades at $1.05.

UST was designed to stay pegged to the US dollar and allow holders to redeem 1 UST for $1 worth of LUNA. When UST dipped well below the dollar mark, huge sell-pressure took down LUNA’s prices.

Kwon wrote in a tweet thread:

“The price stabilization mechanism is absorbing UST supply (over 10% of total supply), but the cost of absorbing so much stablecoins at the same time has stretched out the on-chain swap spread to 40%, and Luna price has diminished dramatically absorbing the arbs.

Before anything else, the only path forward will be to absorb the stablecoin supply that wants to exit before $UST can start to repeg. There is no way around it.”

1/ Dear Terra Community:

— Do Kwon ? (@stablekwon) May 11, 2022

Kwon also said the team endorsed a community proposal to increase UST’s minting capacity from $293 million to $1.2 billion in order to allow the system to absorb UST quicker.

In Kwon’s proposal he references, a community member saying that the move will probably put further pressure on LUNA in the near future, but eventually strengthen the entire system over the longer term.

“Allow more efficient UST burning and LUNA minting, will in the short term put pressure to LUNA price, but will be an effective way to bring UST back to peg, which will eventually stabilize LUNA price.

Yes, billion of UST will be burned, and LUNA will be diluted significantly. Nevertheless, there are no limits in LUNA supply, this market mechanism will actually work to bring stable UST and stable LUNA price (although likely at lower price point for LUNA).”

What Happened?

To understand why LUNA and UST collapsed this past week we should look at its Achilles heel – the Anchor lending protocol.

One of the earliest signs that things were going wrong for Terra came when UST deposits on Anchor started dropping Saturday.

Anchor offers market leading yields of up to 20% on the year to users who deposit their UST on the platform. Before UST started its decline late on Saturday, Anchor was home to 75% of LUNA’s entire circulating supply. That’s $14 billion of UST out of a total circulating supply of $18 billion.

With so much UST locked up in Anchor, most investors were buying the stablecoin with the sole intent of reaping those sweet, sweet Anchor yields. Depending on whom you ask, Anchor’s relationship with UST was either an ingenious mechanism to manufacture utility for the fledgling stablecoin, or a wasteful marketing spend attracting stingy mercenary capital.

According to critics Anchor’s high yields were unsustainable – artificially propped up by Terra builders Terraform Labs (TFL) and its big money backers. A yield decrease, they say, would’ve sent UST depositors fleeing Anchor (and UST) in search of higher returns.

The problem was that TFL and its partners could only afford to subsidize investors for so long. At some point, the money would dry up, and so would Anchor’s customer’s (and UST’s willing holders).

Though Anchor was never forced to decrease its yield rates too significantly, UST deposits dropped sharply through the start of this week, from $14 billion to as low as $3 billion. So much money draining from UST’s primary hub signaled a massive loss in confidence in the entire UST protocol. With few other use-cases for UST beyond Anchor, most withdrawals from the platform probably ended up on the open market.

The massive drain from Anchor onto the open market contributed major selling pressure to the Terra ecosystem.

UST, an algorithmic stablecoin, works with its sister token, LUNA, to maintain a price around $1 using a set of on-chain mint-and-burn mechanics. In theory, these mechanics should ensure $1 worth of UST can be used to mint $1 of LUNA – which is meant to serve as a floating price shock absorber for UST volatility.

The massive sell pressure led to sharp drops in the prices of both LUNA and of UST. Eventually, the market cap of LUNA flipped that of UST for the first time. When there was no longer $1 worth of LUNA for every $1 of UST, some watchful traders feared the entire system might become insolvent, since UST holders would have no clear way to “cash out” into LUNA in the event of a full-scale bank run.

In order to shore up UST’s price, the Luna Foundation Guard (LFG), Terra’s official peg defenders, deployed over $2 billion in its newly formed bitcoin reserves.

Do Kwon started sweeping BTC off the market in recent months in an attempt to backstop Terra should its peg ever need defending.

In its first test of this mechanism, LFG “loaned” billions of dollars worth of reserve assets to professional market makers, draining LFG’s blockchain wallets almost entirely in the process.

As LFG struggles to top up its empty reserves with new investors, market makers are on a quest to actively defend Terra’s peg by deploying rescue capital on exchanges and liquidity pools.

While the rescue capital from Terra’s reserves had some success bumping up the prices of UST and Luna on Tuesday, the prices of both tokens were highly volatile leading into the early morning hours of Wednesday.

It was at this point that all bets seemed to be off for a smooth UST recovery. Even as Do Kwon announced on Twitter a Terra rescue plan was in the works, market confidence in the project appeared to fall to all-time lows. At one point, LUNA – priced over $120 earlier this year – fell beneath a dollar. UST fell below 30 cents for a brief moment, leading to questions around whether the “stable” coin will ever be able regain its stability.

Much of the hundreds of millions of dollars in bitcoin used to rescue UST were likely sold straight to market early this week. Cash-outs to non-BTC currencies would have been necessary for traders hoping to defend Terra’s peg.

Charts of BTC net transfer volumes tell this story, showing massive volume spikes on May 9 and 10 as Terra’s reserves were first deployed. While Terra doesn’t account for the entirety of these spikes, billions of dollars in freed-up Terra reserves would certainly have made an impact.

Terra’s BTC reserve sells likely added more sell-pressure to the market.