Unfolding the Terra-Luna crash
The current worldwide cryptocurrency market cap has fallen to less than 1 trillion dollars. The primary cause of this calamity was the depegging of the UST against the US dollar. Unlike fiat-collateralized stablecoins, UST or TerraUSD is an algorithmic stablecoin of the Terra network.
On May 7, a substantial volume of withdrawals took place on Anchor protocol, a Terra-based lending-borrowing platform which initiated UST’s depeg. However, the Luna Foundation Guard (LFG) attempted to safeguard the peg, but they failed amid the panic caused by the fluctuating price of UST.
Some critics call UST a crypto version of a pyramid scheme, while others say it was a coordinated attack on the Terra network. This blog provides a high-level explanation of stable coins, the historical Terra collapse, what caused it, and what we can expect for the future.
What are stablecoins?
Stablecoins are the cryptocurrencies that are supposed to be pegged to fiat currencies. If some cryptocurrency is pegged to USD, it means their price is supposed to be $1 all the time. The different stablecoins differ by the mechanism that is responsible to maintain the peg.
Types of Stablecoins:
- Fully Collateralized: These stablecoins are fully backed by fiat, treasuries, and other low-risk investments. For example — USDT, USDC, BUSD, etc.
- Overcollaterized: These stablecoins are created by overcollateralized loans and repayment processes facilitated by smart contracts. For example — DAI.
- Algorithmic: These stablecoins are uncollateralized or undercollateralized and an algorithm manages the relationship between the stablecoin and the native token. For example — UST.
What is Terra?
Terra is a proof-of-stake layer 1 blockchain built using the Cosmos SDK, propagating the idea of “decentralized money”. According to Terra’s white paper, the founders’ goal was to fulfill what Bitcoin originally set out to be: a peer-to-peer electronic cash system. Terra ecosystem has experienced tremendous growth recently. The market capitalization of UST grew from $180 million at the start of 2021 to almost $15 billion in March 2022.
What are LUNA and UST?
LUNA is the native token of the Terra network, It has a variety of use cases, some of them are:
- It is used in mining and also as a governance token.
- Users stake Luna to validators who record and verify transactions on the blockchain in exchange for rewards from transaction fees.
- LUNA helps in stabilizing UST.
UST(TerraUSD) is the core algorithmic stablecoin of the Terra network, it is supposed to maintain its 1:1 parity with the U.S. dollar via an algorithmic relationship with Terra’s native cryptocurrency, LUNA. The algorithmic relationship means that LUNA has to absorb the volatility of the UST.
How does UST maintain (or is supposed to maintain) its peg?
Behind the algorithm designed to maintain the peg, there is an arbitrage opportunity that presents itself every time UST loses its peg in either direction.
Whenever the UST supply is too low, and its demand is too high, the price of UST goes above $1. In order to bring back the peg, the Terra protocol lets users trade 1 USD of LUNA for 1 UST at the Terra station portal. This trade burns 1 USD of LUNA and mints 1 UST, which users can sell for 1.01 USD and pocket a profit of 1 cent. This profit might not sound great here, but when done in large quantities these profits add up. Users can mint as much UST as needed from burned LUNA until UST goes back down to $1. As the supply increases, the price eventually comes down.
If the supply is too high, and demand is too low, the price of UST goes below $1. So the protocol lets users do the opposite as above: Users can buy 1 UST for 0.99 USD, then trade 1 UST for 1 USD of LUNA. The trade burns 1 UST and mints 1 USD of LUNA, netting the arbitrage trader a profit of 0.01 UST. The Terra protocol lets users continuously burn UST and receive LUNA until UST reaches $1.
The meteoric rise in demand for UST
As discussed above, Terra was created with the motive of creating a user-friendly platform for electronic cash. It first gained traction among South Korean e-commerce platforms because it offered cheaper transaction fees than most credit card companies and payment processors. Users can pay with Terra stablecoins seamlessly and merchants can accept it as a payment method to lower their cost, as transactions are subjected to a computational fee which is usually below 1% of the transferred value and goes to validators as rewards.
Anchor Protocol is a Terra-based lending and borrowing protocol. It provides UST depositors a 20% annual percentage return. This is known as APY. Borrowers can use bonded LUNA (bLuna) or bonded ETH (bETH) to secure UST loans. It uses an over-collateralized architecture to allow users to borrow, lend, and earn interest with their digital assets. Users can take out loans and deposit savings to earn a yield. Yields earned from the borrower’s interest payments and the staking rewards of the collateral they deposit to borrow are distributed to stakers. The protocol also allows for fast withdrawals and pays depositors a low-volatility rate. It is one of the most well-known stablecoins.
Anchor protocol proved as a good use case for the network’s famous algorithmic stablecoin UST(as users are guaranteed to get 20% APY on their UST deposits to the protocol).
What went WRONG?
On May 7, a large volume of withdrawals from the Anchor protocol (having a TVL of around $16.75 billion on 7th May) started UST depegging. It created a domino effect on the UST pool on Ethereum’s Curve Protocol, the main hub for stablecoin liquidity in all of Defi, which also saw high-volume withdrawals.
Some people believe that the cause of depegging is a coordinated attack, and some believe that the reason is panic-ridden withdrawals. But the depegging of UST is not just influenced by a single event, there are a series of events that led to this situation.
Series of Events
In January 2022, Do Kwon (founder of Terra network) announced the launch of LUNA Foundation Guard (LFG), an organization formed to build reserves supporting the UST peg during volatile market conditions, and also to allocate resources supporting the growth and development of the Terra ecosystem through grants. LFG raises $1 billion in February 2022, through the sale of LUNA tokens to buy bitcoin for UST’s reserve system.
In March 2022, the LFG’s bitcoin wallet address purchased more than 27,000 BTC (roughly $1.3 billion), and the LUNA rises to a new all-time high of $106, during the end of the month LFG purchased 5,733 BTC (roughly $272 million).
In April 2022, during the start of the month, the LUNA’s price reaches an all-time high of $119.2, and LFG keeps buying BTC for its reserve. LFG first purchased 5,040 BTC, boosting its reserve to 35,768 BTC (roughly $1.6 billion at that time), then again LFG added $173 million bitcoin to its wallet over a weekend. LFG also $100 million in AVAX with UST stablecoins. Terraform labs ( the organization behind the UST algorithmic stablecoin (UST) and its LUNA token) gives 10 million LUNA tokens worth $820 million at that time to LFG. During mid-April, UST becomes the third-largest stablecoin, and the circulating supply of LUNA hits an all-time low of 346 million tokens as LUNA tokens are burned to keep up with the rising demand for UST.
Now comes May 2022, when everything starts falling apart. On May 7, someone swapped 85 million UST for 84.5 million USDC on Curve. On the next day, UST dropped to a low of $0.985 after a series of large dumps on Terra’s lending protocol Anchor and on stablecoin exchange protocol Curve. LFG commits to loaning $750 million of BTC to market makers to defend the peg of UST and another $750 million of UST to be used to buy back BTC after volatility subsides. As UST struggles to recover to $1, deposits on Anchor protocol plunge below $9 billion from $14 billion, also on the same day ANC, the protocol’s token falls by 35%.
UST again loses its $1 peg for the second time and falls to as low as 35 cents. There were claims that UST depeg was due to a Soros-esque attack. Anchor protocol saw a drop in locked value to $11 billion over two days.
By May 12, LUNA’s price falls 96% in a day, pushing it to less than 10 cents. The Terra blockchain was halted for the first time at block height 7603700, after LUNA falls sharply in price, threatening the network’s security. The Terra blockchain was again halted for the second time, at block height 7607789 which resumes activity after nine hours. On May 13, the Okx and Binance exchanges end trading of Terra tokens after UST loses its dollar peg and LUNA slumped by more than 99%. Binance later resumes trading in LUNA. Do Kwon submits a “Revival Plan” that would see the network ownership distributed to UST and LUNA holders through 1 billion new tokens.
By May 16, LFG confirms it depleted its BTC reserves from around 80,000 bitcoins to 313 bitcoins during the attempt to save UST’s peg.
Impact on the ecosystem
The Terra LUNA crash had a great impact on the ecosystem, as over $17 billion in crypto value has been wiped out through luna and UST alone. There have been anecdotal reports of self-harm by those who had most of their savings staked in UST — though these can’t be confirmed, it’s clear that a lot of people lost a lot of money in the collapse. Many who were exposed to LUNA and UST would have sold off big parts of their crypto portfolio to recoup some of the damage, pulling the entire market down.
This collapse also raises the question about the stablecoin, as a whole. Even though USDT (Tether), and USDC (Circle’s USD) are not algorithmic stablecoins like UST but still people started doubting them. For instance, New York’s attorney general last year accused tether, the biggest stablecoin, of lying about how much it actually held in dollar reserves. Since May 11, an estimated $10 billion Tether has been withdrawn, as people speculate that it may be the second stablecoin to depeg.
The collapse of UST has caught the attention of powerful politicians and regulators. Secretary of the Treasury Janet Yellen said on May 10 that UST’s depegging “simply illustrates that stablecoins is a rapidly growing product and there are rapidly growing risks.” Also, the desire to regulate stablecoins is rising after the depegging of UST.
What’s NEXT?
On May 16th, 2022, Do Kwon proposes to fork Terra without UST, calling the current chain “Terra Classic.”
On May 25th, 2022, Terra Classic users passed governance proposal 1623, which outlined the genesis of a new Terra chain. This proposal also described a genesis distribution of Luna which would be airdropped to users of the Terra Classic chain based on pre-depeg and post-depeg snapshots.
On May 27th, 2022 the phoenix-1 Terra mainnet launched, ushering in a new era of development by the Terra community. Users can find their airdropped Luna by viewing the same wallet address that was present during either snapshot and switching their Terra Station network to the phoenix-1 mainnet.