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CZ’s FAQ 8 - On LUNA/UST and Taking the Right Risks

2022-05-20

In the past week, it’s been difficult to escape the UST/LUNA crash. In fact, every interview I participated in revolved to some extent around the situation. To clarify my thoughts on the topic, I’ve collected my answers together, including my views, lessons learned, spillover effects, systematic risks, resilience, regulations, and more.

The UST/LUNA incident was a regrettable one that affected many people. At Binance, our first focus is always to protect affected users. Sadly, there are no great solutions here that can please everyone. Many proposals were discussed in the community. Unfortunately, each had its drawbacks. 

I voiced my opinions about the incident openly on Twitter. Binance has also volunteered to let the Terra project team focus on helping the retail guys first before us.

There Are Many Lessons to Be Learned Here

Let’s take a look at the design flaws. Theoretically speaking, when you peg to one asset using a different asset as collateral, there will always be a chance for under collateralization or depegging. Even if it is over collateralized by 10x, the collateral asset can crash more than 10x. Nothing is 100% stable (relative to something else) in this world.

The most stupid design flaw is thinking that minting more of an asset will increase its total value (market cap). Printing money does not create value; it just dilutes existing holders. Exponentially minting LUNA made the problem a lot worse. Whoever designed this should have their head checked.

The other fundamental flaw was the over-aggressive incentives. Specifically, Anchor’s 20% fixed APY to push for (in-organic) growth. Let’s strip away all the fluffy stuff and look at fundamentals. You can use incentives to attract users to your ecosystem. But eventually, you need to generate “income” to sustain it, i.e., more revenue than the expenses. Otherwise, you will run out of money and crash. 

However, in this case, the “income” concept is confused as the project team probably included their own token sales or appreciation in the value of LUNA as “income”. This approach is flawed. People come in because of the incentives, yes, and the valuation of LUNA goes up. And more incentives are given out to more people. But you haven’t created any value yet. 

High APYs Don’t Necessarily Mean Healthy Projects

It’s now obvious that the whole thing was built on a self-perpetuating, shallow concept. While Terra did have an ecosystem with some use cases, the speed of growth of the ecosystem did not match the speed of the incentives used to attract new users. The growth was “hollow”. Eventually, the bubble burst, and here we are. 

Key lesson: don’t just chase high APY. Look at fundamentals.

Where Attempting to Restore the Peg Went Wrong

The Terra team was slow in using their reserves to restore the peg. The entire incident may have been avoided if they had used their reserves when the de-peg was at 5%. After the value of the coins had already crashed by 99% (or $80 billion), they tried to use $3 billion to do the rescue. Of course, this didn’t work. 

In this case, it didn’t look like a scam. It was just (sorry for the lack of a more polite word) stupid. Lesson two: always be operationally extremely responsive.

The Terra team was also very slow and infrequent in their communication with the community, which further eroded any lingering trust users had with them. Lesson three: always communicate frequently with your users, especially in times of crisis.

Lastly, I have mixed feelings about the revival plans provided by the Terra team. But as I said, regardless of my personal feelings, we will be here to support the community’s decision.

Will There Be Spillover Effects?

Yes, of course. There have already been shockwaves sent throughout the entire crypto ecosystem. USDT de-pegged to 0.96 for a bit but recovered quickly. Many crypto projects were and are still negatively impacted in many ways. If nothing else, most crypto prices dropped. Even bitcoin dropped about 20%. 

Many people withdrew their funds from high APY projects. But if you think about it, this may not be a bad thing in the long run. Some shocks are good for building a solid foundation. Some solid projects actually “benefited” in a way. BUSD went to 1.1 in pegging and saw an inflow of funds over the last weeks.

Resilience Is Present in the Crypto Ecosystem

Honestly, I am pleased by the resilience the crypto industry has shown. The combined size of UST and LUNA was bigger than Lehman Brothers when it failed. Bitcoin only dropped roughly 20% from $40,000 to $30,000. This sometimes happens even when there is only positive news for bitcoin. Overall, most other projects stood up fine.

One thing that’s hard for people who are used to centralized systems to understand about decentralized systems is their resilience. In a centralized system, all the banks operate similarly (the regulations require them to do so). They all take reserves from a central bank, and when one bank fails, it has a spillover effect on all the other banks. In a decentralized system, all the stablecoins work in different ways. There are no common standards or reserves. However, when one fails, the others are less affected. 

Even without bailouts, all other major stablecoins withstood the shock, and most other crypto projects are fine.

Will Regulators Toughen Their Stance on Stable Coins given This Incident?

I don’t know what each regulator thinks or will do. So far, I have seen mostly encouraging responses from the few who regularly keep in touch with me. Of course, this is a biased selection as the people who keep in close contact with me are mostly very crypto-friendly. 

I do believe we need more guidelines around how stable coins should be regulated. But one regulator said it best: 

“We definitely need to pay more attention to algorithmic stablecoins, but let’s not let one failed company kill the entire industry. We should continue to push forward.”

How Do We Avoid Systematic Risks like These in the Future?

This is the trillion-dollar question. I don’t think there is an absolute answer here. Nothing is risk-free. The fiat currency you use today has its risks too. The oldest currency in use today is less than 330 years old, the British pound. All the currencies before that are gone. We could ban or shut down everything, but that would also kill innovation. To prevent bank failure and mismanagement, we don’t shut down all banks.

At the end of the day, there are several things you can do to reduce systematic risk.

  1. As an investor, diversify your portfolio. Don’t put all your savings in one coin because it offers a high APY (Annual Percentage Yield).

  2. In fact, stay away from super high APY investments. Those hardly last. High APY = high risk.

  3. Most importantly, educate yourself. Learn about financial literacy every day. Visit Binance Academy and explore everything it has to offer (sorry, I have to do a bit of sales here).

As an industry, we are resilient. While instances like the one with LUNA and UST are regrettable, we are committed to playing a crucial part in building a sustainable, enriching blockchain ecosystem for all.