Luna Foundation Guard's Crisis Response Fails to Prevent UST Collapse

Despite accumulating $3 billion in cryptocurrency reserves, the Luna Foundation Guard's (LFG) plan to protect the UST stablecoin from market turmoil was not fully operational during last week's market crash. As UST lost its dollar peg, LFG scrambled to improvise solutions, including $1.5 billion in loans to maintain the peg and potential additional funding. The lack of a formal structure for the forex reserve and delayed implementation of a smart contract to stabilize UST made it vulnerable to a market rout.

Luna Foundation Guard's Reactive Crisis Management Fails to Avert UST's Plunge

As the cryptocurrency market plunged in tandem with traditional markets, the Luna Foundation Guard (LFG) found itself scrambling to salvage the stability of the UST stablecoin, as the absence of a formal structure for its forex reserve exposed the project's vulnerability to market volatility.

LFG's hastily deployed cryptocurrency loans and reported pursuit of fresh capital underscore the project's unpreparedness for a crisis that had been brewing for weeks. Despite accumulating over $3 billion in reserves, primarily in Bitcoin, LFG had yet to implement a critical smart contract that would have linked the reserve to the blockchain and provided a mechanism to stabilize UST during a crisis.

"The reserves had reached their desired size, but the infrastructure to utilize them was not in place," observed Vetle Lunde, analyst at crypto research firm Arcane Research. "Add a bleeding market and poor weekend liquidity to the mix, and you've got yourself a great opportunity to attack."

UST, the largest algorithmic stablecoin, lost its peg to the dollar on Sunday, a move that sent shockwaves through the crypto market. The stablecoin's price plummeted to as low as 68 cents on Monday, underscoring the limitations of algorithmic stablecoins, which rely on a complex system of trading incentives to maintain their price peg.

In response to growing concerns about the stability of algorithmic stablecoins, Terraform Labs, the developer behind the Terra blockchain, created the Luna Foundation Guard to establish a reserve that would support UST's peg in case of a crisis. However, LFG's accumulation of crypto assets, including becoming one of the largest Bitcoin holders, proved insufficient without a working mechanism to deploy the reserve during turbulent market conditions.

Under a proposal by Jump Trading, an investor in LFG, the reserve would have allowed traders to swap UST for Bitcoin at the price peg if UST fell below 98 cents. This arbitrage incentive would have stimulated demand for UST and stabilized its price. However, the crisis occurred before this system could be implemented.

Jose Maria Macedo, a council member of LFG, indicated that the Bitcoin swap mechanism was expected to be launched by the end of the following week, but co-founder of Terraform Labs, Do Kwon, acknowledged that the testnet launch was still weeks away.

Critics have long questioned the stability of algorithmic stablecoins, arguing that they are inherently vulnerable to market downturns and exploitation of design weaknesses. Sean Farrell, an analyst at FundStrat, suggested that the recent turmoil surrounding UST was not a coincidence but a deliberate attack on its fragile architecture.

Farrell's analysis highlighted a series of events that led to the crisis: LFG's removal of $250 million from the UST-3pool on Curve, a stablecoin exchange platform, followed by a seller swapping $85 million of UST for USDC on Curve, disrupted the pool's balance and triggered a negative feedback loop that pushed UST's price below 98 cents.

LFG's subsequent $1.5 billion loan to traders to restore the peg was unsuccessful, as the continued decline in traditional markets provided ample ammunition for the original short seller to continue their attack on Curve. Market makers who initially supported UST by selling Bitcoin realized the futility of their efforts, as falling prices diminished their available resources to support the peg.

Even if LFG manages to restore UST's peg, the damage to its credibility has been substantial. Investors are withdrawing funds from Anchor, the yield-earning protocol that fueled much of the demand for UST, and LFG is reportedly seeking $1 billion in fresh capital to bolster its reserves.

While LFG may succeed in the short term in stabilizing UST, the long-term reputational damage and eroded trust in the stablecoin are undeniable. As of press time, UST continued its downward spiral, trading at 73 cents, while LUNA's value plummeted by 66% in 24 hours, highlighting the precarious nature of algorithmic stablecoins and the need for more resilient mechanisms to safeguard the stability of cryptocurrencies.