This week's story: Terra-Luna’s crash: what happened?
This week's story: Terra-Luna’s crash: what happened?
mai 16 2022
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The de-pegging of the algorithmic stablecoin TerraUSD ($UST) and the concurrent crash of its counterpart $LUNA have marked the “Lehman moment” of this May’s crypto markets capitulation.

Mainstream media and crypto-haters were quick to jump on the occassion: from “all cryptos are scam” to “all stablecoins are scam”, very few had the intellectual vigor necessary to find out what has really happened, and what lies ahead. Let us try now.

How does Terra-Luna work?

Terra is a blockchain specifically created to maintain a decentralized stablecoin – a cryptocurrency that keeps its value pegged to the USD via a set of algorithms and incentives.

It uses a Proof-of-Stake consensus, where validators stake $LUNA to have a chance of adding new blocks to the blockchain and earn commission. Only top 130 stakers can become validators, and they distribute a part of their rewards to stakers who have delegated their coins to a validators’ pool.

The money for the rewards comes from the fees that Terra charges for every creation/destruction of its stablecoins, a process motivated by the market:  

📉 if $UST price falls, users can burn it and mint $LUNA, paying the fees in $LUNA; the burnt $UST reduce the overall supply, which makes UST scarcer and its price goes up (as does $LUNA’s yield: (UST+LUNA)/Cheaper LUNA = higher APR)

📈 if $UST price rises, users can mint it and burn $LUNA, paying the fees in $UST; $LUNA becomes scarcer and its price goes up

The swap fees spread is adjusted by the market module in order to maintain balance between $UST and $LUNA pools.

This system is innovative in many ways: creating a blockchain to support a stablecoin (other stablecoins, both centralized and decentralized, exist on legacy blockchains such as Ethereum or BSC), using stablecoin mints/burns as a source of revenue for staking rewards (other protocols use coin inflation or coin price as a source)… However, as we now know, Terra did not stand the test of time.

So what happened?

The elastic money supply has worked well so far, but as for any product on the open market, both $UST and $LUNA are subjects to the market sentiment, and if that one goes awry, the consequences can be dire.

For Terra, it all started with Anchor.

Anchor is a DeFi lending-borrowing protocol that has been steadily reducing the yield for UST deposits, decreasing every months as long as there were more lenders than borrowers (which was the case).

On May 5th, Anchor was holding over $17Bn in TVL (total value locked), out of which $13Bn locked in $UST. Comparing to the total $UST market cap of that time, the $UST locked in Anchor represented over 70% of all $UST in circulation. That’s huge.

Many believe that it was Anchor’s high yields that fuelled Terra’s rise and the minting of billions of stablecoins. However, as the yield began to decrease, people started pulling their $UST out of the protocol, and as often in finance, the whole thing snowballed:

  • over the course of last weekend Anchor lost $3.6Bn of value locked, falling to $13.4Bn on May 9th,
  • these people turned to Terra’s mint-and-burn system, burning $UST and minting $LUNA, which supply has skyrocketed and price fallen -45%
  • the high transaction load congested the Terra blockchain (which has minting limits), so that some exchanges have suspended withdrawals, spreading mistrust in the ecosystem,
  • this is when the $UST started losing its peg,
  • which further precipitated the exodus from Anchor, but this time people turned to the exchanges to sell their $UST and their $LUNA,
  • and further precipitated the fall of $LUNA price, which by now has fallen so low that it could not fulfil its function of balancing the $UST,
  • the $UST has definitely lost its peg, falling as low as $0.64 on May 10th

The death spiral was impressive in its scale and speed, but Terra’s creator Do Kwon had a plan.

Attemps to save $UST

Collateralization

When it comes to decentralized stablecoins, most popular solution so far has been collateralization. Pioneered by MakerDAO and its USD-pegged stablecoin DAI, it basically means holding reserves in other crypto (most often ETH, since MakerDAO exists on Ethereum) that significantly exceed the amount of minted DAI, so that the peg would hold even in times of volatility. Terra’s mechanism is totally different, but it appears that its creators have had their doubts.

Luna Foundation Guard, a non-profit tasked with maintaining the Terra ecosystem, announced in the end of March its intention to buy $10Bn in Bitcoin for its reserves, and has so far bought some $3.5Bn worth of it. When the $UST de-pegged on May 10th, it announced it will be using its Bitcoin reserves on the open market to try and stabilize the $UST. On-chain analytics firm Elliptic has tracked the movements of LFG’s 80’394 BTC to Gemini and Binance exchanges. It is unclear how these funds were used, but the $UST jumped to $0.93 shortly afterwards.

Unfortunately, this was not enough, and $UST has definitely lost its peg in the following days. $UST now trades at around $0.13, while $LUNA trades at $0.0002.

The community still awaits LFG’s reporting on what it has done with its $3.5Bn in Bitcoin, and it promised to deliver soon.

Kwontative Easing and burning

On May 11th Do Kwon shared his Terra rescue plan on Twitter.

In order to absorb the supply of stablecoins that wish to exit, he proposed to increase Terra’s minting capacity x4, which would subsequently create much bigger amounts of $LUNA and dilute the value of the coins already in possession. In other words, make the current holders pay for the system stabilization.

The solution resembled too much the favourite Central Bank’s tactics, so it was dubbed Kwontative Easing. However, as much as the Central Bank’s QE, this one had little success.

Other proposals included burning the $UST in the community pool, burning the $UST that exist on Ethereum, and staking 240 million $LUNA to protect the network from governance attacks.

In the meantime, both $UST and $LUNA continued their tailspin, making Do Kwon and Co finally admit the stablecoin’s defeat and divert their attention to its basis – the Terra blockchain and its ecosystem.

Saving Terra

On May 14th Do Kwon published a Twitter tread admitting that $UST in its current form is not viable, and that the main focus now should be preserving the community and developers that have contributed to Terra’s success.

Indeed, unlike other stablecoins, Terra is a blockchain, and it can serve as a building foundation for DApps of all sorts, and its developer community is indeed an important one.

Kwon’s Revival Plan consists in validators resetting the network ownership to 1Bn coins, distributed among:

  • $LUNA holders before the depegging (40%)
  • $UST holders pro-rata at the time of the new network upgrade (40%)
  • $LUNA holders at the final moment of the chain halt (10%)
  • community pool for the future development (10%)

This incentive is basically a hard fork for the Terra blockchain and is supposed to reimburse (more or less) historical $LUNA holders, while stimulating the demand for $UST and creating a new demand for $LUNA. As to the stablecoin’s problem that got it in trouble, Do Kwon is optimistic that the community will find its way to fix this, and it will discuss it “once the dust has settled”.

Other community members, such as Jiyun Kim (CEO of DSRV, a company that runs a big validator node on Terra), are not thrilled with the hard fork idea and propose to move to a brand new blockchain, driven by the community.

We do hope that Terra community will find a solution to rescue the significant amount of intellectual work and development put into it by the creators and the community. After all, most innovation do progress in spirals, learning from past mistakes to produce a better result in the future.