This article is the second in a four-part series by YaaS Analytics discussing algorithmic stablecoins, with a focus on the UST crash and the resulting fallout. The series consists of four articles:
2. The Rise of Terra Classic
Note that at the time of writing, the original Terra Chain has been rebranded as Terra Classic and Terra has been relaunched as Terra 2.0 after the UST collapse. When we refer to Terra throughout this article, we are referring to Terra Classic.
What is the Terra Blockchain?
The Terra blockchain is a proof-of stake public blockchain with mainnet launch in April 2019. Development on Terra began in 2018 by the South Korea based Terraform Labs, a software development company founded earlier in 2018 by Do Kwon and Daniel Shin. Terra was initially intended to be an e-commerce platform, and to create a group of price-stable cryptocurrencies pegged to the world’s major fiat currencies, such as USD, EUR, JPY in order to facilitate transactions and address the regionality of money. Included among these fiat-pegged currencies was what Terra considered their flagship currency TerraSDR, that was pegged to the International Monetary Fund’s (IMF) Special Drawing Rights (SDR) currency basket in order to offer a cryptocurrency that was superior in reducing global risk.
In Terra’s white paper, the founders postulate that ‘[s]ince the value of a currency as a medium of exchange is mainly driven by its network effects, a successful new digital currency needs to maximize adoption in order to become useful.’ The white paper further goes on to state that there is great demand for a decentralized, price-stable currency in both fiat and blockchain economies, and that if such a currency was successful, it would be the best use case for cryptocurrencies. Thus, it would seem from the beginning that maximizing user adoption was one of the primary objectives of Do Kwon and the other founders of Terra.
The price of Terra stablecoins such as UST are algorithmically maintained by the protocol’s native token LUNA, which absorbs the price volatility of Terra stablecoins through a burn & mint mechanism. Simply put, new UST would either be minted or burned depending on whether UST was trading above or below its intended price. This mechanism would expand or contract the supply of UST, thus decreasing or increasing the price, respectively. We go more in-depth on the mint and burn mechanism used by algorithmic stablecoins in our previous article, The History of Algorithmic Stablecoins.
In addition to this, LUNA is also the staking and governance token, where LUNA coin holders can stake LUNA for rewards and use its weight to vote on governance proposals.
The Growth of UST
TerraUSD (UST) — now known as TerraUSD Classic (USTC) — was one of the algorithmic stablecoins running on the Terra blockchain that was pegged to the US dollar. UST launched in September 2020 and experienced meteoric growth during 2021, exploding from a market cap of $182mm at the start of January 2021 to $16.5 billion by the end of March 2022, leading UST to become the 4th largest stablecoin on the market, behind USDT, USDC and BUSD. The price of LUNA soared from $0.63 to $109 over the same timeframe — an increase of 17300% — with LUNA’s market cap peaking at $41.05b on April 3rd 2022, making it the 6th largest cryptocurrency by market cap.
While this growth was aided by the crypto bull market of 2021, it was predominantly driven by Anchor, a savings protocol on the Terra blockchain that promised an annual percentage yield (APY) of almost 20% on UST deposits. This astronomical APY led investors to flock to the Anchor protocol in droves, propelling Anchor to become by far the most dominant protocol on Terra. On May 5th, the total value locked (TVL) on the Terra blockchain was $29.65b; on the same day, there was $17.05b locked on the Anchor protocol, meaning that 57.5% of the value on Terra was locked in Anchor. As well, on April 23rd it was reported that up to 72% of all UST in circulation was deposited on Anchor. Thus, it is clear that the majority of DeFi activity on the Terra blockchain was occurring on Anchor.
The Anchor protocol, launched in March 2021, was the biggest driver of user adoption on Terra. Anchor is a savings, lending and borrowing platform built on and for the Terra blockchain. In their whitepaper, Nickolas Platias et al describe Anchor as “a savings protocol on the Terra blockchain that offers stable yield powered by block rewards of major Proof-of-Stake blockchains.” Anchor differentiated itself from other DeFi savings protocols by offering a much higher, non-cyclical interest rate wherein lenders would deposit UST into the Anchor pool, and then would earn up to 20% APY on their deposit. UST in this Anchor pool would then be lent out to borrowers for a period before eventually having to be repaid. Borrowers would have to put up significant collateral in “stakeable” digital assets, which Anchor would then lock up to generate yield through a liquid staking mechanism to pay lenders. Basically, the staked tokens would be liquidated by the Anchor protocol into UST for depositors in order to pay them the target earnings of 20%. As well, Anchor incentivized borrowing by paying out rewards with its native token ANC. This idea of earning while borrowing was an incentive used to drive early adoption of the protocol. Although you had to over-collateralize your loan as a borrower on Anchor as well as pay high interest relative to other lending platforms, the ANC rewards generated through borrowing offset these fees. This effectively allowed the borrower to earn while borrowing. The stable high interest rate was incredibly enticing to investors, and when combined with this idea of earning while borrowing resulted in rapid growth for the protocol and UST. The protocol surpassed a whopping 4 billion TVL within the first 6 months of launch.
The Issues with Anchor
There were a number of fundamental issues with Anchor as a lending protocol. First, the 20% deposit interest was so attractive that it led to an imbalance between borrowers and lenders; this got to the point where by January 2022 there was one borrower for every 4 lenders. Additionally, borrowing always tends to dry up when markets are in a downward trend — as seen at the end of 2021 when markets started to cool off. UST adoption was increasing, deposits on anchor were increasing but borrowing — and thus collateral — was decreasing at a staggering rate. Borrowing and lending algorithms such as Anchor depend on borrowers putting down collateral, with this collateral then being staked by the protocol. The rewards from this staked collateral are then combined with the charged interest from borrowers and used to feed the depositors earnings. The discrepancy between the borrowers and lenders caused rapid depletion of the Anchor reserves, forcing Terraform Labs to continuously inject UST into these reserves in order to maintain the high yield rates promised to the lenders. The true yield was estimated to be lower than 8%, less than half of the promised yield, which in reality was simply a marketing ploy to drive user adoption.
This marketing scheme had another negative effect on the Anchor protocol; it created synthetic demand. This means that most users invested in Anchor and ultimately UST did not necessarily believe in the product, but instead were only invested to turn a quick profit. This left Anchor especially vulnerable to a bank run, as these users are more likely to withdraw their UST at the first sign of trouble in order to minimize losses. Thus, when the price of LUNA began dropping, a death spiral quickly initiated as investors rushed to withdraw their UST. Evidence of this synthetic demand can be found by looking at what borrowers would do with their ANC rewards. Using data pulled from Flipside Crypto, illustrated below is the proportion of Anchor borrowers that sold their ANC rewards within 7 days of receiving them for rewards paid out between January 1 and May 1. Rewards were considered sold only if the exact reward amount was swapped entirely for UST, and only users borrowing on Anchor were considered. Finally, only ANC rewards that were sold on Anchor or Astroport (an AMM built on and for the Terra blockchain) were considered. Here we see that in the 4 months leading up to the UST crash, 39% of borrowers would sell their ANC within a week. This reinforces that much of the user demand for Anchor was indeed synthetic, as many of the users borrowing from the protocol opted to cash out their rewards rather than hold a stake in the protocol. Hence, despite its explosive growth, demand for Anchor was primarily driven by its astronomical rates rather than a belief in the future of the protocol.
Trouble on the Horizon
In May 2021, while cryptocurrency markets were enduring a downward trend UST experienced its first major depegging event when the price dropped more than 5 cents below its peg. The price began to depeg in the first week of April, when it dropped to $0.9944. UST continued to fluctuate between $1 and $0.995 for the next month and a half, before dropping to $0.9838 on May 20th, and then further dropping to $0.9457 on May 22. The price quickly recovered, and by the start of June UST had regained its peg. This incident sparked fear in the ecosystem and questions began to persist about the sustainability of a true algorithmic stablecoin peg during volatile market conditions.
On January 19 2022, Terraform Labs announced the creation of the LUNA Foundation Guard (LFG), a non-profit organization founded with the goal of maintaining and safeguarding UST’s peg to the US dollar. Terraform Labs realized that they needed to begin building reserves in order to better insulate UST’s peg, and so they began accumulating assets via the LFG. According to Terraform Labs, the LFG was “mandated to build reserves supporting the $UST peg amid volatile market conditions” as well as to “allocate resources supporting the growth and development of the Terra ecosystem” through grants. In truth, by this point Terraform Labs was very aware that they should move away from a true algorithmic stablecoin model and should begin to collateralize their asset. Seen below is the makeup of the LFG’s reserves as of April 2022, immediately before the crash.
Here we see that the vast majority of reserves were held in BTC, followed by LUNA and AVAX as the only other reserves above 1%. Note that ~98.5% of the LFG’s reserves were comprised of volatile cryptocurrency, with USDC and USDT as the only stablecoins. While this has some benefits, such as greater decentralization, it also comes with downsides, namely the volatility of the crypto market means that the value of these reserves can quickly change and the market volatility that would cause the reserves to be used would be correlated with the value of the reserves themselves. As well, crypto assets are more vulnerable to price manipulation than traditional fiat assets.
Do Kwon had publicly stated that the LFG planned to bolster its reserves to $10b by the end of the 3rd quarter. However, time ran out and these reserves were not enough to protect UST’s peg when the next round of volatility came. While UST began to temporarily fluctuate from its peg May 8th, 2022, Tuesday May 10th, 2022 marks a shocking and tragic day for many as LUNA and UST dropped to $16.87 and $0.68 respectively, thus beginning their ultimate downward spirals. By Friday, May 13th, both LUNA and UST had flatlined, dealing a 40 billion blow to LUNA and UST holders with fallout triggering one of the most shaking crashes in crypto market history.
In our next article, we will further delve into the crash of UST, investigating how and potentially why it occurred as well as a statistical analysis of the factors behind it.
By Jack McKay & Julie Paterson