A Tale of Two Coins: Terra Luna

Ponzi Scheme, Bernie Madoff, George Soros vs Bank of England, Lehman Brothers, and even Frank Capra’s “It’s a Wonderful Life”… Terra Luna’s epic crash that shook the world seems to be a perfect combination of all the infamous financial incidents (one being fictional) above. It’s the perfect storm that wiped out tens of billions of dollars in a matter of days. Apart from being a true tragedy for countless investors, it’s an extremely attractive topic to discuss. So, I will try to paint a picture of what happened to Terra Luna.

Before jumping into Terra Luna and the huge mess it created, let’s talk about stablecoins, first. Stablecoins are cryptocurrencies that are aimed to be stable (thank you Captain Obvious!) in the overpoweringly volatile cryptocurrency universe. Most of them are pegged to USD. Because of this feature, stablecoins are –unlike other cryptocurrencies- pretty useful as a medium of exchange. While the most prominent stablecoins (USDT, USDC, etc.) ensure price stability by keeping the asset they are pegged to as collateral, new and ambitious ones (UST, DAI, MIM, etc.) aim to enable it through algorithmic formulas. In short and in theory, stablecoins are a very good shot to bank the bankless masses and decentralise global finance.

Terra Luna’s UST is (or, more appropriately, was) a prime example of algorithmic and decentralised stablecoins. Attracting all sorts of investors to itself with its dazzling fixed 20% annual yield, at its peak, it had a marketcap of 19 billion USD.

Now, what is Terra Luna? Terra Luna is a blockchain protocol and payment platform which was built by Terraform Labs in 2018, a South Korean software company, based in Singapore. The co-founder of this company is now-a-celebrity Do Kwan. Do was born 27 years before Terra Luna, again in South Korea. After studying computer science at the prestigious Stanford University, he briefly worked at Apple and Microsoft. Not being satisfied with working for big tech, Do returned South Korea with the aims of becoming big tech himself.

The year it was founded, Terra Luna raised 47 million dollars across three ICOs. So, the project was very well funded. Later on, smart money kept flowing into Terra Luna before it became the star of the show. Using the Cosmos SDK (a framework that makes thousands of TpS possible for blockchain platforms), Terra Luna blockchain’s mainnet went live in mid 2019. Now, even though UST was supposedly a decentralised stablecoin, with its 130 validators, Terra Luna is quite centralised.

Terra Luna ecosystem was built upon a delicate algorithm consisting two cryptocurrencies; the stablecoin UST and the blockchain’s native token LUNA. As it can be understood from the blockchain’s allegoric name, UST and LUNA were meant to sustain a balance for the Terra Luna universe. To put the algorithm behind it simply;

• On Terra Luna, 1 dollar worth of LUNA can always be burned to mint 1 UST, and 1 UST can always be burned to mint 1 dollar worth of LUNA.
• If/when UST’s value goes higher than 1 USD, any LUNA hodler can burn 1 USD worth of LUNA to mint 1 UST, then directly sell that 1 UST in the market and receive more than 1 USD (as UST’s value is higher than USD) and make a profit. This process creates a sell pressure on UST and decreases its value to 1 USD, and also a buy pressure on LUNA and increases its price.
• If/when UST’s value goes lower than 1 USD, any UST hodler can burn 1 UST to mint 1 USD worth of LUNA, then directly sell that 1 USD worth of LUNA in the market and receive 1 USD (value of which is higher than 1 UST) and make a profit. This process creates a buy pressure on UST and re pegs its value to 1 USD, and also a sell pressure on LUNA and reduces its price.

This simple algorithm works fine in a bull market but in a bear market, Terra Luna’s arbitrage incentive possesses the risk of triggering a death spiral. For instance, when UST de pegs, market participants exploit this mechanism to make a quick buck and force LUNA’s price to go down. This situation lowers LUNA’s capacity to re peg UST. If LUNA’s price drops too much (and more importantly, if LUNA’s market capitalisation goes below UST’s marketcap) then the whole system collapses. That single weakness makes the interdependence of LUNA and UST a deadly dance.

And why does Terra Luna operate this game? One word: seniorage. From all the transactions mentioned above, Terra Luna receives a tiny fee. In its short life, the blockchain generated billions of dollars of revenue from those fees. This revenue was later on used to incorporate Terra Luna even more into the smart contract universe by building bridges to many other layer one smart contract solutions with the aims of making UST the most popular and accessible stablecoin. This strategy worked so well, demand for both UST and LUNA skyrocketed. From its ICO price ($0.8), at its peak, LUNA’s price went all the way up to $120 and it made LUNA the 5th largest cryptocurrency out there!

While UST was very popular on many DEFI platforms, the main demand (80%) for it was stemming from Anchor Protocol, a DEFI platform on Terra Luna ecosystem. Famous for its fixed 20% yearly interest rate, Anchor Protocol was the primary reason of UST and LUNA’s success. Its Madoffesque stable return was so attractive, even the global bear market that started in November 2021 couldn’t hold up Terra Luna’s success. Just until a month ago, the blockchain was having its most glorious days.

Despite all that queen’s weather in appearance, Terra Luna wasn’t free from criticisms. Quite the contrary, there were many, questioning the sustainability of the system. For instance, last November a Twitter user (@FreddieRaynolds) claimed that Terra Luna was a sitting duck, waiting to be attacked by a big player with a “Soros style Black Wednesday attack”. Being mocked by Terra Luna’s arrogant CEO Do Kwon at the time, this prediction would later come true with all its details.

As I have stated earlier, apart from Anchor Protocol’s ridiculous 20% fixed yield, Terra Luna had a soft underbelly; the death spiral. Actually, the blockchain came close to it in three different occasions when UST de pegged remarkably. So, the Terra Luna team were well aware of the risk. What was their solution? Incorporate Bitcoin into the structure to make Terra Luna bullet-proof. Genius!

According to this plan, BTC was going to be added to the algorithm mentioned earlier as a second redeeming option. In turbulent times, market participants would prefer using BTC (as it’s bigger, stronger and more credible) instead of LUNA to burn UST and that would reduce the sell pressure on LUNA, and consequently save the ecosystem from a death spiral.

For this purpose, Luna Foundation Guard (LFG) was established and it immediately started to accumulate Bitcoin with the funds generated through the seniorage mechanism (and also by selling its LUNA holdings) I mentioned earlier. In a short span of time, LFG’s Bitcoin holdings exceeded 80,000 BTC (one of the three biggest Bitcoin hodlers at the time). Then, to secure the platform even further, Terra Luna went the extra mile and added Avalanche’s (another noteworthy layer one smart contract platform) native token AVAX to its stability reserves as a third option.

In appearance, everything in Terra Luna’s garden was rosy.

Then came the 7th of May 2022. An unknown but definitely a big player executed an epic attack on Terra Luna. The followings are alleged and yet to be confirmed;

• The date was specifically chosen as on that day Terra Luna was extremely vulnerable due to a massive liquidity transfer.
• The perpetrator borrowed 100K BTC from a market maker.
• The perpetrator offered Do Kwon 25k BTC in return of UST.
• Do Kwan took the bait, and unwittingly put UST in an even more vulnerable position.
• At that point, the perpetrator aggressively sold all the BTC and UST they held, causing massive slippage and triggering a cascade of forced selling in both assets.
• The real problem was the perpetrator knew that Anchor Protocol, which was one of the biggest LUNA & UST hodlers, was already shaky (for offering a fixed 20% interest rate in a bear market) and this crash would trigger more withdrawals than Anchor could repay.
• These forced withdrawals and selling triggered a massive sell off in Luna, thus further de pegged UST and wiped off the market participants’ confidence in the stablecoin.
• The perpetrator then bought back the BTC to cover its short position with a whopping 950 million dollars of profit.

In the following days, LUNA token’s price declined from its all-time-high by -99%… then -99% again… then another -99%, and finally, an additional -99%. Once sitting at the glorious $120, LUNA fell all the way down to $0.000001. Similarly, UST, the algorithmic “stablecoin” which was supposed to be pegged to 1 USD, fell to $0.06. When all was said and done, 1 million dollars invested in LUNA just a week before the crash is now worth a measly three dollars. In the absence of a centralised authority to provide some sort of a bailout, in a matter of days, a shocking 45 billion USD melted away. The market was so hot, LUNA’s one day trading volume was over $2.8 trillion! This was the biggest and the quickest financial crash in history.

It could be argued that, the whole crash could have been avoided if Anchor Protocol’s insanely high interest rates were reduced, and the UST deposits in that protocol had a withdrawal waiting period (a week or a month) so that a bank run like this wouldn’t be possible. Instead, Terra Luna became yet another example of a centralised structure -claiming to be decentralised- taking its place in the dusty pages of history.