~$200 billion wiped off! Here’s what happened on Terra-fying Monday

Monday, May 9, 2022, will go down as one of the worst days in crypto history. The UST depeg has not only tanked the entire market, but the surrounding narrative and underlying conspiracy theories are fascinating as well.

Before we go any further, a quick recap.

Yes, it’s been an absolute bloodbath, Bitcoin dropped below $30,000, while ETH dropped below $2,000. So, what was the root cause behind this?

Well, check this out:

Terra’s massive crash was the biggest reason behind the marketwide sell-off. However, what caused this crash? What was the root cause behind one of crypto’s greatest wealth destruction events? Who launched this George Soros-style attack on crypto?

Before we answer any of these questions, let’s give you a quick history lesson.

Meet Do Kwon and Terra

This is Do Kwon.

This man is responsible for creating Terra. The Terra protocol has two coins — LUNA and UST. UST is an algorithmic stablecoin that remains pegged to $1. UST isn’t backed by a basket of cryptos or fiat currency. Instead, it stays at $1 via the burning or minting of LUNA. So, LUNA’s supply mechanics are responsible for keeping UST at $1.

There are some more nuances in these tokenomics that we have to note.

• More UST in the ecosystem = Less LUNA. The goal for Terra is to burn off all LUNA for UST.
• You can always redeem 1 UST for $1 of LUNA. This holds true even if the value of 1 UST is below $1.
• If the demand for UST goes up significantly, the supply of LUNA becomes extremely scarce, making LUNA very valuable (on paper).

To understand the last point, let’s do a thought experiment.

• Imagine that the price of 1 LUNA has reached $1 million.
• So, someone can burn 1 LUNA to mint 1 million UST.
• Now, if the price of 1 LUNA reaches $1 for whatever reason, that person can redeem their 1 million UST to get 1 million LUNA (for a total of $1 million).

Do you see the issue here? But, of course, this wasn’t the only problem with Terra.

The UST-Anchor Protocol quandary

So, how do you increase the number of UST users? With high utility and rewards. Firstly, UST has found an immense amount of utility in various DeFi protocols. Prior to this Monday’s crash, the UST-3CRV pool on Curve Finance had $1.3 billion TVL. Plus, the DeFi apps on Terra’s ecosystem had close to $30 billion locked in.

Second, and way more importantly, staking UST on Anchor Protocol — a DeFi app built on Terra — gives you ~20% APY! So, how is Anchor paying off the 20% APY, you ask?

Well — not efficiently.

This ~20% yield comes from the proof-of-stake yield and the interest earned from their borrowers. Borrowers need to lock up a large amount of collateral on Anchor and pay over 10% of APR on their loans.

Why would borrowers want to give up so much of their yield? Every time you lock up collateral on Anchor, you get a large bag of ANC tokens. Unfortunately, because of Terra’s growing popularity, Anchor hasn’t been able to keep pace. Anchor has been steadily dipping into its reserves to pay out these yields.

As you can see, these reserves have steadily decreased over time.

Now, keep in mind that Terra can always reduce the APY, but they will lose users and reduce UST utility if they do so. However, this also gave rise to something else that was completely counterproductive. UST holders were incentivized just to mint UST and lock them in Anchor and do absolutely nothing.

So instead of using UST for payments, users simply locked them up and did nothing. As such, UST became low-velocity tokens when compared to USDT and USDC. Low velocity means UST wasn’t changing hands frequently via transactions or payments.

So, to summarize:

• Anchor Protocol gave ridiculous yields to attract more users.
• Demand shot through the roof as the 20% APY became unsustainable.
• Users were now just locking up UST on Anchor instead of doing anything of note. Before the crash, the total supply of UST in circulation was around $18b, with over $10b locked in Anchor.

Sustaining via LFG

Terra formed the Luna Foundation Guard (LFG) to maintain UST’s peg and sustain Anchor’s yields. They did so by recapitalizing the Anchor yield reserve with 450 million UST. The LFG has also been on a Bitcoin buying spree, with over $3.5 billion BTC bought as reserves to restore UST’s peg when needed. If UST ever fell below $0.98, BTC would be sold for UST to reduce UST’s market supply.

The George Soros-style annihilation

Many, like Blockstream CEO Adam Beck, have compared the coordinated attack on Terra to the legendary short position that George Soros took against the Bank of England. So, what exactly did the attacker do?

Step #1: The Curve Attack

The attacker borrowed 100,000 BTC. Of this 100,000:

• The attacker used 25,000 BTC to buy UST through OTC deals.
• The remaining 75,000 BTC was used to short LUNA.

A quick note before we go any further:

Curve Finance is an automated market maker that specializes in stablecoin swaps with low slippage. Usually, algorithmic stablecoins are highly dependent on Curve for their liquidity. The attacker used $350 million of UST to drain Curve’s UST liquidity pools.

This caused the initial depegging as UST dropped to $0.972.

Step #2: LFG starts eating into reserves

The depeg caused manic as more users began to sell off their UST. LFG started eating into their BTC reserves to restore the peg. Initially, they sold $750 million of their $3.5 billion BTC reserves. Dumping the BTC caused Bitcoin to drop significantly.

This was when the attacker played some serious 4D chess.

They knew that LFG would eat into their reserves and dump BTC. They anticipated this move, so they already had a Bitcoin short position open. So, they knew what Terra would use to counter the initial short and stood to profit with another short.

Step #3: Anchor gets #rekt

Alright, so they successfully short BTC, and the plunging prices cause mass hysteria. Everyone is selling off their UST and LUNA. People start removing liquidity from Anchor. Over 50% of the funds get withdrawn from Anchor within 48 hours. This greatly messes up the supply and demand equation, causing UST to drop to as low as $0.60.

As Terra continues to try and regain the peg, they keep selling off their BTC reserves. They have already sold off over $2 billion of their Bitcoin reserves.

Addressing the conspiracy theories

Several posts out there suggest that the attackers are Citadel and Blackrock. Citadel is infamous for being the ones that saved the hedge funds from the GameStop short squeeze. It is also worth noting that both of these companies have spoken positively about Bitcoin in the past year. It has also been suggested that Gemini offered the initial 100,000 BTC loan to the attacker(s). These theories gained a lot of steam when Cardano founder Charles Hoskinson posted them on his profile.

All three parties have released statements denying their involvement in the attack. Hoskinson has also deleted his tweet.

Looking ahead

Let’s sum up the market sentiment right now:

Jokes aside, a lot of people lost a lot of money. Some have even lost their life savings. So, I hope that the market recovers and they make back some money for their sake.

Regarding Terra and Do Kwon, the market has a weird way of making us all eat humble pie.

In November 2021, an account named Freddie Raynolds perfectly laid out how Terra is vulnerable to the exact attack that it suffered this week. Let’s just say Do Kwon didn’t respond kindly to the tweet. This didn’t age well at all. I am having a tough time seeing how Terra will ever recover from this. The sad part is that Terra had the second-largest DeFi economy before the attack.

The total value locked in Terra’s DeFi ecosystem has collapsed from ~$30 billion to ~$2 billion. I genuinely believe that this was the biggest casualty of the attack. In addition, Anchor Protocol’s ANC also reached an all-time low.

My final thoughts

Anyone working on algorithmic stablecoins needs to have a long hard look at their code and tokenomics to understand the long-term sustainability of their protocol. Do you need Ponzinomics to give stupidly large yields to attract users? If yes, then maybe it’s time to relook at what you are bringing to the table.

The main thing that screwed up the entire market is the interconnectivity. Terra and UST had their claws in DeFi, Ethereum, and even Bitcoin. As such, the attacker could sink the entire market by attacking Terra’s tokenomics. Keeping this in mind, builders need to be more responsible about their protocols.

Janet Yellen and the US regulators have been pushing for stablecoin regulations for a long time. In fact, Yellen has recently cited UST as the primary reason why regulations are required. So, let’s see how this pans out. Maybe stablecoin regulations will indeed help clean up this space.

All-in-all here’s hoping for a better future.

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