Terraform Labs Founder Do Kwon Arrested: Examining the Collapse of TerraUSD and Terraform Labs

TL;DR

• Terraform Labs, or Terra for short, was founded by Stanford University-educated, ex-Apple and Google Engineer, Do Kwon.
• TerraUSD is an algorithmic stablecoin developed by Terraform Labs, aimed to maintain a $1 peg using Luna tokens.
• Terra Labs halted the operation of Terra in May 2022 due to the demise of its ecosystem that was brought on by investors dumping their Terra stablecoin, TerraUSD, en masse.
• The ecosystem’s collapse was triggered by a loss of confidence and a massive sell-off triggered by Anchor Protocol’s interest rate cuts and two large Curve Finance withdrawals. The Luna Foundation Guard’s efforts to stabilize the situation were insufficient.
• On March 23, Terraform Labs founder Do Kwon was arrested in connection with the $40 billion crash of TerraUSD and Luna.

On March 23, Terraform Labs founder Do Kwon was arrested in Montenegro, as he is wanted in both the U.S. and South Korea in connection with the $40 billion crash of the firm’s cryptocurrency TerraUSD and Luna.

Terra Labs halted the operation of Terra in May 2022 due to the demise of its ecosystem that was brought on by investors dumping their Terra stablecoin, TerraUSD, en masse.

In today’s article, we will learn about the stablecoin TerraUSD itself, its issuer Terraform Labs, and the state of the Terra ecosystem, including the aftermath of the major crash in May 2022 and the most recent SEC case against the company and its founder.

What is Terraform Labs?

Terraform Labs, or Terra for short, was founded by Stanford University-educated, ex-Apple and Google Engineer, Do Kwon.

Terraform Labs created the Terra ecosystem, which is an open-source, community-owned blockchain that hosts a vibrant ecosystem of applications. On Terra, users can build applications and organizations with developer tools, or try out existing ones by connecting a wallet.

The company’s initial platform was called Terra and is now known as TerraClassic. Terra 2.0 was launched on May 28, 2022, in an attempt to revive the Terra ecosystem. Terra 2.0 allows users to build customized applications and organizations or interact with existing ones.

What is TerraUSD token and how it suppose to work?

The TerraUSD stablecoin, formerly traded as UST, was Terra’s blockchain stablecoin, and its development was announced in September 2020. It was an algorithmic stablecoin aimed to maintain a value of 1 USD by using a parallel floating rate cryptocurrency, Luna (LUNA), to back up the target peg.

Most stablecoins are backed by cash or other traditional assets, making TerraUSD risky compared to its competitors. Here are some strategies Terra deployed to reduce price voilatity:

• UST/LUNA Algorithmic Stablecoin

The UST/LUNA algorithmic stablecoin system uses a linked value between UST and Luna tokens to maintain UST’s stable $1 value. Smart contracts manage the exchange between UST and Luna, adjusting token supplies to ensure stability. Initially, the system has 100 UST and 20 Luna tokens, with 1 UST equivalent to $1 USD of Luna, and 1 Luna worth $5.

When UST’s price falls (e.g., to $0.90), traders buy UST, swap it for Luna, and sell Luna for $1, profiting from the difference. The smart contract decreases UST supply and increases Luna supply, pushing the UST price back to $1.

Conversely, if UST’s price rises (e.g., to $1.10), traders buy Luna, swap it for UST, and sell UST for a profit. The smart contract increases UST supply and decreases Luna supply, returning the UST price to $1.

• Anchor Protocol

Anchor Protocol, a decentralized lender on Terra’s blockchain, helps stabilize UST’s price by offering above-market interest rates (~20%) on UST deposits. This generates demand for UST, while Anchor lends out UST and other cryptocurrencies to users seeking staking rewards. The increased demand and lending activity contribute to UST’s price stability.

• Luna Foundation Guard (LFG)

Luna Foundation Guard (LFG) is an organization founded by Kwon to support the Terra and Luna ecosystems. By minting and selling Luna tokens, LFG acquired Bitcoin and other cryptocurrencies, amassing $1.5 billion in holdings. With plans to accumulate up to $10 billion worth of BTC, LFG aims to provide financial backing to strengthen and stabilize the ecosystems.

So how did Terra collapsed?

Terra’s collapse can be attributed to a combination of factors that led to a loss of confidence in the ecosystem, ultimately resulting in a massive sell-off of UST and Luna tokens. One possible trigger was Anchor Protocol’s decision to cut interest rates for crypto deposits in May 2022, which may have contributed to investors becoming wary of the platform’s stability. Additionally, two large withdrawals from Curve Finance destabilized UST, leading to the printing of more Luna tokens to maintain the peg. This flooded the market and further eroded the tokens’ value.

The inability of the Luna Foundation Guard (LFG) to effectively intervene and stabilize the situation also played a crucial role in the collapse. Although LFG sold most of its Bitcoin holdings to defend UST and Luna, their efforts were insufficient to halt the “death spiral” that ensued. This was in part due to the limited resources in the LFG’s war chest and the potential negative impact of selling Bitcoin on the broader crypto market. Consequently, the Terra stablecoin and Luna token became essentially worthless, causing significant losses for thousands of investors.

Terra Collapse Timeline

• May 2, 2022: Anchor Protocol cuts interest rates (~20%) for crypto deposits, possibly triggering the UST/Luna sell-off.
• Early May 2022: Two large withdrawals (~$250 million) from Curve Finance destabilize UST. The UST/Luna exchange link prints more Luna tokens, flooding the market and driving values down.
• May 16, 2022: Despite Luna Foundation Guard (LFG) selling most of its Bitcoin to defend UST/Luna, Terra stablecoin and Luna token become essentially worthless, causing massive losses for investors.
• Late May 2022: Terra 2.0 launches as a hard fork of the original Terra blockchain, now called Terra Classic. The original LUNA token is renamed Luna Classic (LUNC), and LUNA 2.0 is introduced with a locked supply of 1.0 billion.
• February 17, 2023: The U.S. Securities and Exchange Commission (SEC) charges Terraform Labs and its founder, Do Kwon, with defrauding U.S. investors who purchased Terra USD and Luna digital assets.
• March 14, 2023: The Department of Justice (DOJ) and the Federal Bureau of Investigation (FBI) launch an investigation into the collapse of algorithmic stablecoin Terra USD (UST) and Terraform Labs. Former staff members are questioned by U.S. law enforcement.
• March 23, 2023: Terraform Labs co-founder Do Kwon is charged by US prosecutors with orchestrating a yearslong cryptocurrency fraud that wiped out at least $40 billion in market value.

~ By Lu Tian