Summary: Author: Weisha Zhu  ---Answers to the concepts in the article "Invite Satoshi Nakamoto to Welcome the New World" Lessons from Luna's crash In order to understand the adjustment of the Federal Reserve, let us first understand something that has never happened in modern finance. The adjustment of the Federal Reserve is much easier to understand ...

Author: Weisha Zhu 

---Answers to the concepts in the article "Invite Satoshi Nakamoto to Welcome the New World"

Lessons from Luna's crash

In order to understand the adjustment of the Federal Reserve, let us first understand something that has never happened in modern finance. The adjustment of the Federal Reserve is much easier to understand than Luna.

4.2.1 Luna's crash process

Luna Coin is a cryptocurrency launched by Terra Lab, a blockchain platform, and its founder is Korean Do Kwon. South Korea is also where it has the most customers. Terra is also the general term for a group of stablecoins, the most famous of which is the U.S. dollar-linked algorithmic stablecoin UST. The stabilization mechanism consists of the stablecoin TerraUSD (UST) and the backing currency Luna. UST has maintained a price of 1 UST, about 1 USD, for a long time and was once the third largest stable currency in the world; the price of Luna is not fixed and is determined by the value of Terra's entire ecology. Both TerraUSD (UST) and Luna depend on each other. The algorithmic mechanism between Luna and UST is approximately that every time a new UST is minted, Luna worth $1 will be destroyed (burned), and vice versa. In this regard, stablecoins such as USDT have some algorithmic stabilization mechanisms. Still, USDT and others are the endorsements of actual U.S. dollars, and the certainty is much higher than that of Luna's endorsement.

From an investor's point of view, when the price of 1 UST is greater than 1 U.S. dollar, you can buy Luna for 1 U.S. dollar to mint a new 1 UST to earn the difference; and when the price of 1 UST is lower than 1 U.S. dollar, you can buy 1 UST at a low price in exchange for value Luna for $1. When UST fluctuates, you can use the algorithm formula 1 USD Luna to be constant at 1 UST for arbitrage. Luna can absorb the fluctuation of UST currency value and close UST itself to the value of 1 USD for a long time.

    Luna is an equity currency representing Terra ecology's value and circulates on the exchange. The projects in its ecology all use UST to circulate. The Terra ecosystem has covered more than 100 original projects. This ecology has 2.5 million active users, a vast number of users for blockchain projects. Luna reached a high of $119.5 on April 5, 2022, and a maximum market value of $41 billion. Terra is a platform benchmarked against Ethereum, which was more than 200 billion at the time, so the valuation of Terra is not expensive. The reason for the upsurge is that I bought luna, exchanged it for UST, and then mortgaged it, promising an annual return of 19%, which constituted the demand for Luna. The blockchain also has a demand valuation, which will rise as long as there is demand. The price at this time is determined by hype and driven by a minimal volume. The story of a high return and an ecological platform is enough to tempt the market, with a return of 19% attracting as much as $17 billion in pledges.

The 19% interest rate is too high, and if it doesn't make money, how can it pay it back? Terra said it would lower the price, which is a negative signal. The price and logic are unreasonable, and seasoned hunters know it well. Predators are waiting for their chance.

An opportunity presented itself. According to Taiwan's"Financial News" report: On May 7, 2022, in order to prepare for upgrading the capital pool, Terra LFG, the UST management team, withdrew 150 million UST from 3Crv, UST's main trading venue, which was 20% of the platform's liquidity; unexpectedly Ten minutes later, multiple accounts began to sell UST in large quantities, resulting in an imbalance of UST liquidity. Judging from the phenomenon, no one knows why and who withdrew. The market will suspect that something important has happened and start selling. It is difficult to examine whether the short side is conscious, unconscious, or a team.

In order to stabilize the price relation between UST and the U.S. dollar, Terra and market makers sold Ethereum and Bitcoin reserves one after another and bought back UST for destruction. However, the destruction of UST requires the issuance of more Luna, which leads to a downward spiral of the dual currency and a complete decoupling from the U.S. dollar. Even the rescue of the exchange Binance is difficult to recover; on May 11, the rescue failed. According to the statistics of the coin circle, the attack funds started by the short side totaled about 300 million U.S. dollars, which not only caused the UST of 18.6 billion and the Luna of the market value of 40 billion U.S. dollars to almost zero but also dragged down Bitcoin and other stablecoins. In just five days, the total market value of the coin circle shrank by 30%, and 500 billion U.S. dollars disappeared out of thin air. How much of the 500 billion is real money? It should be a lot. Unfortunately, I haven't found the formula and relevant information to calculate the actual loss.

4.2.2 What do we get from it?

This matter is worth summarizing. First, it is a phenomenon that does not exist in traditional finance.

18.6 billion UST is real money, and the market value of 40 billion has bubbles and real money. Judging from the coin circle projects related to the crash, lost more than billions of dollars Luna. The bailout funds are billions, plus the funds of retail investors; there should be tens of billions; the wealth of at least 30 billion yuan was wiped out in a blink of an eye. However, the short side fund was about 300 million U.S. dollars but caused the entire currency circle to lose 500 billion U.S. dollars. From May 7th to May 12th, 2022, the 6-day blockchain has completed de-bubbling, and the storm's center is a stampede. Through this incident, it can be understood that the Fed's water collection and interest rate increase are to eliminate the bubble, puncture it in advance, and exchange small losses for the financial system's stability. If the application of the Terra ecology is regarded as an industry, it is even worse. It is all zero, and its value is underestimated. They are innocent; the industry is the most injured by every financial adjustment because they cannot escape. Financial stability is paramount. How stable? The method should be simple and easy to understand. 

Conclusion 1: From the luna incident, it can be seen that the stampede is the absolute destruction of social wealth.

Conclusion 2: Humans are not yet capable of manipulating a complex and comprehensive financial platform, and this innovation is very risky.

The Luna ecosystem is a central bank, a market maker, a provider of financial products, and an ecological platform. This story is so big that there is no profit but only benchmarking valuation. Benchmarking with Ethereum, Luna is not expensive. They are in too hurry and want to get big quickly. UST19% interest is given, which makes customers increase rapidly. However, how can they support the interest payment without profit? It is the hole in his story. They have to cash out the value of the rise in the currency price as a profit. The most direct value of attracting customers is to promote the rise of currency prices. The total number of users exceeds 4 million, and retail investors account for the vast majority. The rise of the currency is positive feedback. If it rises, it will rise again. Does a stock have so many customers? Retail investors have no valuation experience, and the market does not have an early warning like stock market analysts. Once there is a sign of trouble, it will immediately reverse.

Once it reverses, it falls and falls again. Stampede appeared, it was a 24-hour trade, and it fell to the bottom in 6 days. At present, the value of luna reflects the value of Internet customers, which is equivalent to about US$50 for a customer, which is less than 300 million. At this time, the value of the project on it returned to zero, and the loss was huge. Why is there this value? It is worth the price even if he sells the project. Compared with its market value of 41 billion when it crashed, the difference between the two is about 140 times. How big must a story be to support this price? The bottom of Bitcoin is its mining cost, approximately $17,000. Bitcoin is driven by demand, and its rise must have story logic. The bitcoin standard is the biggest story.

Conclusion 3: If there is no intervention, the project's bottom line is its restructuring price, also called the replacement price. The value is underestimated, which is also when Buffett is most willing to buy. He scoured a pile of undervalued quality assets for the best.

Conclusion 4: If the value created by customers is just hype, the project has no other profit model, and the project party can make profits beyond the market; the story is a Ponzi scheme.

Conclusion 5: The rapidly rising price is not real, and the position of the Luna bullish fund is not enough to resist the stampede.

After the collapse of Luna, speculators aimed the stablecoin USDT again because the transparency of the fiat currency he held was not enough, and the market was in doubt. When the withdrawal reached 14 billion, the market value of USDT dropped from 82 billion at the end of May 2022 to 68 billion at the beginning of June, and the attacker stopped. The overall decline was 17%. After the USDT attack, the stablecoin USDC was also redeemed, and there was also a drop of 12 billion from the end of June to October. The overall decline was 21%. Meanwhile, the fully transparent stablecoin Dai, backed by bitcoin and Ethereum, saw a slight rise with little change in market capitalization.

Conclusion 6: Stablecoins backed by real assets also need to be transparent.

During this process, Luna and its partners also rescue the market, spending no less than 3 billion in funds. From the perspective of USDT, the spending has reached 20% of the market value, and the stable currency must have at least more than 30% of the fund reserves to withstand the withdrawal of coins, which is conservatively estimated to be 50%. But not enough for luna.

Another problem with Luna is the algorithm problem. Due to the destruction of UST, the additional issuance of Luna caused the sale of Luna. Luna price drop, more low-priced Luna issuance, after the destruction of UST, causing new sell-offs. Cause a downward spiral. So it's not 50% able to stop it.

Conclusion 7: There is no prior algorithm simulation by the risk control department, and there are loopholes in the system. The cost of gaining experience through ecology experiments is too high.

Conclusion 8: The proverb that radicals die quickly is verified again.

A similar thing happened in the 2008 financial tsunami in the United States. The United States resorted to quantitative easing and bought house bonds, bailing out banks and insurance. If not saved, America is Luna. It will destroy the wealth created by the American people and the people of the world, and the economy will go back at least ten years. For Paulson's kneeling, The world should thank him. But the side effects of life-saving drugs are too significant to be used as vitamins. We will analyze later the side effects of unlimited quantitative easing and the evil consequences of the Ponzi economy.

If Luna had a rescue, would this be the result? For example, if Luna has a loan of 10 billion, it can be rescued at a position of 15 billion to 20 billion, and it may be back to 40 billion now. Because its ecology is still there, rescue is reasonable, and it is unreasonable to have no rescue mechanism.

Conclusion 9: It is necessary to design a suitable rescue mechanism. We considered this when designing the Bitcoin standard.

Conclusion 10: There is no source of cost and profit in Luna's algorithm, and it will not add value to Luna's equity. The 19% interest has no apparent source, which will dilute the equity.

Conclusion 11: Luna does not have the ability of the lender of last resort, and he lacks the ability of the central bank.

Conclusion 12: Even if Luna does not adjust the ecology, it needs 100% asset endorsement, and central bank functions not be required.

Are Stablecoins Central Banks? It is 100% asset endorsement. It performs part of the functions of the central bank, and all currencies use it as a ruler of value, But they should have the responsibility of the lender of last resort. The current stablecoin does not have this responsibility.

Does Ethereum have a central bank function? No. Does Binance BNB have a central bank function? No. The stablecoin BUSD issued by Binance is pegged to the U.S. dollar. So why doesn't he use BNB as Luna's status? Because algorithmic stablecoins don't work? No. The stability of each stablecoin has an algorithm. The difference is the endorsement asset. Using an unstable asset as an endorsement requires a risk control mechanism. Luna does not have a risk control mechanism. Beforehand, consider whether it breaks the anchor and how to pull it back.

In the previous article, we discussed M1 adjustment and M2 adjustment. The M2 market regulates the price of Luna, and Luna is the market maker of UST, but UST is directly regulated by M1. When the market is hyping, it faces a constantly changing price target, and this change is random. Two random factors were opened up. This financial phenomenon has not been seen in traditional finance. Algorithmic adjustment improves over traditional financial human adjustment, but the algorithm must be scientific. From the experimental point of view, the Luna algorithm fails. The stablecoin is adjusted by only one factor and is as successful as the Hong Kong dollar. Innovation is significant, but not all innovations are successful. Luna's invention failed. There is also value in summarizing failures.

What is the biggest lesson? If you don't think well, take small steps.

When we study the Bitcoin standard, we need to check all the examples of success and failure. We can't cross the river by feeling the stones. Only successful cases can be used, and we can go.

In the next section, we discuss the difficulties facing the Fed in regulating the economy.