Terra’s Luna Amid Its $60 Billion Implosion. Photographer: Gabby Jones/Bloomberg
In the early hours of May 16, the night sky turned copper red as the year’s solitary lunar eclipse conjured a rare Blood Moon. For holders of the LUNA cryptocurrency, the phenomenon must have felt like a celestial joke. Days earlier, the native asset of the Terra blockchain had plummeted from $80 to under $1 a token, reducing $40 billion in value in an event that’s been dubbed Mt. Gox 2.0.
Crypto’s darkest hour since the insolvency event that shuttered Mt. Gox exchange in 2014, LUNA’s demise has eclipsed the collapse of BitConnect and the market crash of March 2020.
“I believe the core issue that drove Terra’s initial success is also what led it to a catastrophic failure,” ventures Victor Young, Chief Architect at Analog, “According to Terra’s whitepaper, [founder] Do Kwon wanted a stablecoin infrastructure that was better than Bitcoin for payments and robust enough to rival Ethereum’s dApp ecosystem. This meant creating a stablecoin product that could compete directly with fiat currencies in the traditional markets. The entire project, unfortunately, lacked transparency.”
As the saying goes, only when the tide goes out can you discover who’s been swimming naked. As the waters receded from the Terra ecosystem, leaving LUNA holders high and dry, it transpired that a lot of those who should have known better were caught bathing in the buff. From hedge funds to influencers, investors of all kinds were, to use the vernacular, rekt.
The cryptocurrency industry is nothing if not adept at reinventing itself, however, and in the wake of Terra’s demise, leading lights have vowed to learn from its failures and ensure that history cannot repeat. The disaster, sparked by the failure of Terra’s algorithmic stablecoin UST, induced a “death spiral” that slashed the dollar-pegged asset to mere cents and saw the LUNA token hemorrhage 99 percent of its value.
Many in the crypto industry believe the project’s implosion provides an opportunity to de-risk and design more robust systems that will withstand extreme economic shocks. This is likely to be too little to late for policymakers and regulators driven by consumer protection and market stability mandates who have set out to tame crypto.
How a synthetic derivative can call itself a stablecoin in the first place amplifies the absence of a robust enough industry standard for stablecoins to protect consumers, and this is likely to attract the further ire of policymakers seeking to regulate stablecoins. The term “stablecoin” implies stability through (low-risk) fiat or asset backed reserves versus a synthetic fiat peg managed by an algorithm with a lack of transparency to (high risk) underlying assets.
“To the vocal critics of Terra’s algorithmic design – you were right and we were wrong,” wrote a contrite Delphi Digital, whose investment arm lost $10 million, “We understood the risks of the algorithmic model upfront and sought to be transparent about them throughout; however, it’s clear we miscalculated the risks.”
Preston Byrne, partner at Anderson Kill, and one of crypto’s preeminent legal beagles called out algo stablecoins in 2018 with Basecoin and Base Protocol, the predecessor to Terra, with a pithy conclusion: “this is an exceedingly bad idea.”
Algorithmic stablecoins – dollar-pegged crypto-assets that are not backed by fiat – have a long and ignominious history. Every attempt at creating an “algo stable” up until now has failed due to the complexity of creating a token that can hold a death grip to 1 USD when placed under extreme sell pressure.
“The common denominator when it comes to stablecoins depegging is under-collateralization,” explains COTI CEO Shahaf Bar-Geffen, “We saw it happen with UST and now DEI [another algorithmic coin that also recently lost its peg]. I believe that only those stablecoins that are protected by overcollateralization can prevent a bad outcome by prohibiting burning/minting coins.”
UST – Terra’s algorithmically controlled stablecoin – was supposed to be different, and for a long time it was. 12 months ago, the LUNA token was trading for under $5, but as the crypto bull market kicked into high gear LUNA soared, raising the Total Value Locked (TVL) on the network to billions of dollars. At its peak in early April 2022, LUNA reached $116, providing monumental returns for its early backers.
Everyone from HNW individuals to moms and dads FOMO’d into Terra, whose UST stablecoin was regarded as a low-risk option for savers. The volatile LUNA token served as the collateral for Anchor protocol’s UST, which paid out a generous 20 percent yield.
Alkemi Network Co-Founder Brian Mahoney doesn’t mince his words in his Terra post-mortem, saying, “It is unfortunate that UST was mislabeled a stablecoin as its growth was fueled by greed, excessive leverage, and a massive cash burn financing its nearly 20 percent risk free rate.” Ouch.
As seasoned crypto observers will attest, the long-term success of a project relies on the quality of the code and the sustainability of the incentives. Terra had capable developers, but the network incentives appeared dubious at best. As early as last year, critics were debating flaws in UST’s algorithmic model and highlighting possible attack vectors.
On May 7, the prophecy finally came to pass when the Terra network succumbed to the sort of attack its detractors had long predicted. The jury is still out on whether it was a coordinated attack by rich whales or the work of a lone wolf, but what is indisputable is that UST’s economic model was an accident waiting to happen.
When a monied player performed a major sell-off of UST on Curve protocol, the dollar peg dropped to $0.98, and that was only the beginning. Terra figurehead Do Kwon, a messianic leader not known for his humility, brushed off the incident as being little more than a speed bump, but a fatal blow had already been struck. Over the next five days, UST and LUNA embarked on a race to the bottom. Not even the sell-off of Luna Foundation’s ample Bitcoin reserves was enough to reinstate the UST peg.
“The fundamental reason behind Luna’s collapse was due to the complication of managing the UST peg across centralized and decentralized trading venues,” opines James Taylor of CeDeFi exchange Unizen, “The attacker cleverly chose Curve stableswap to attack the protocol which imposed the maximum damage and incited panic.”
“The Terra LUNA/UST crash was shocking, but not without premonition,” reflects ParallelChain Lab CEO Ian Huang, “All algorithmic stablecoins suffer inherent points of failure as they are mainly sustained by the arbitrage system and assumed-normal market conditions. The straw that broke the camel’s back in Terra was its flawed tokenomic model and lack of diverse utilities supporting the ecosystem, which resulted in a too-easy loss of confidence and further aggressive panic selling.”
“When hundreds of thousands of people collectively lose billions of dollars through a DeFi app promoted as a safe savings account rather than a risk-on investment, by some of the biggest and most reputable names in crypto, regulation is most definitely on the way,” predicts Millicent’s Kene Ezeji-Okoye.
“Although it may come as a surprise to many, there are some key industry players, like FTX’s CEO Sam Bankman-Fried and the U.K.’s Financial Conduct Authority who know that smart regulation might just be the only thing that can save crypto from itself and truly catapult the sector into the mainstream,” adds Ezeji-Okoye.
While LUNA and UST holders bore the brunt of the meltdown, greater macro forces started the chain reaction.
“We are seeing a domino effect where the global supply chain crisis is contributing to high inflation and in turn the high volatility of the crypto market,” explains Benjamin Bilski, CEO of German fintech NAGA Group.
Alkemi’s Brian Mahoney sees cause for optimism, predicting, “Despite the shadow cast on the stablecoin segment of the market, I think the sector will emerge much stronger. I am looking forward to the continued contributions from thoughtful, reputable, and well intentioned stablecoin projects, such as USDC, DAI, and FRAX to bring stability and well-built products to crypto. These strive to be true stablecoins with strong fundamentals.”
“UST’s devaluation is having significant effects on overall sentiment and we are seeing a declining number of monthly active DeFi users that could threaten existing business models,” adds Lucas Mateu, Co-founder and CEO of Vent Finance.
Not all of the flak directed against Terra has been steered towards its flawed algorithmic stablecoin, as the hubristic Do Kwon has also come under fire.
“Do Kwon constantly silenced critics who pointed out flaws in the stablecoin’s algorithm,” recounts Analog’s Victor Young, “He even mocked an economist for being poor. Any discourse regarding what caused UST to crash cannot ignore the fact that the stablecoin was not pegged to any non-crypto collateral. Instead, it used a pairwise token system where users swapped Luna to UST and vice versa for a guaranteed price of $1, relying on a weak and manipulative consensus mechanism.”
As for where crypto goes from here, market experts expect further downside coupled with a flight to crypto market stalwarts such as BTC.
According to Ben Caselin, Head of Research & Strategy at AAX, “We may see a big shift in dominance in favor of both Bitcoin and Ethereum, and while turbulence could drag for weeks, a renewed focus in the market on quality, decentralized networks over frivolous coins and risky experiments can be incredibly bullish for the one asset that started it all, bitcoin.”
For the developers, applications, platforms, and users that called Terra their home, the network’s spectacular collapse has been difficult to stomach. Some have decided to exit the failed ecosystem and set up shop elsewhere, Cosmos perhaps, a community-centric network that’s made overtures to Terra’s displaced devs.
For Do Kwon and his close-knit team, there are few viable options. One is to rebuild Terra from the ground up, this time without the ticking time bomb of an algorithmic stablecoin. Whether this can be done and whether anyone in the ecosystem or market will have confidence in a rebuild is another matter.
Terra’s Luna Amid Its $60 Billion Implosion. Photographer: Gabby Jones/Bloomberg