The collapse of the algorithmic stablecoin UST and the highly capitalized token LUNA was a real shock to the crypto industry. Within days, the savings of many users and multimillion-dollar assets of large companies were wiped out.
Shortly before the collapse, the Terra ecosystem was second only to Ethereum in terms of TVL, including projects like MakerDAO, Uniswap, Compound, and other veterans of decentralized finance. The Anchor platform ranked third in the overall DeFi Llama rating.
The meteoric rise of Terra USD (UST) and the popularity of algorithmic stablecoins inspired many developers to create similar projects and reserve crypto funds.
However, everything changed in a matter of days: UST suddenly lost its peg to the dollar, and the associated token LUNA almost completely devalued.
The Collapse Shook Confidence in Algorithmic Stablecoins
The crash of LUNA and UST shook the crypto community’s confidence in the prospects of algorithmic stablecoins. The events within the Terra ecosystem attracted the attention of regulators and mainstream media. The collapse of LUNA and UST also had a negative impact on the broader market, causing significant problems for several DeFi projects.
A Giant with Feet of Clay
Even at the peak of their popularity, there were skeptics doubting the infallibility of Terra’s mechanisms. For instance, in late 2021, a user named FreddieRaynolds warned the community in a series of tweets about the project’s vulnerability to well-coordinated attacks involving significant capital.
In early May, shortly before Terra’s collapse, the deposit interest rate on Anchor was reduced for the first time to just below 18%. This decision aimed to smooth out growing disparities and address several issues, including the depletion of the project’s reserves.
In response, users began to withdraw assets from the protocol en masse. On May 7, Anchor’s deposit volume exceeded 14 billion UST, but within a day, it dropped to 11.77 billion UST, a 16% decrease.
Amid the capital outflow from Terra’s flagship project, the Curve Finance team reported that someone had started selling UST en masse, causing the stablecoin to briefly lose its peg to the US dollar (trading near $0.98 on May 8). The developers noted that these actions “met with strong resistance” in the form of counter-sales of ETH and stETH.
Suspected Market Manipulation
Mudit Gupta, Head of Security at Polygon, pointed out that the UST incident was accompanied by several suspicious operations.
According to him, on May 7, Terraform Labs removed 150 million UST in liquidity from Curve, after which an unknown newly created address transferred over 84 million UST to the Ethereum network. Minutes later, ETH was dumped, triggering a sell-off, Gupta noted.
Shortly thereafter, the company withdrew an additional 100 million UST from Curve.
As the stablecoin’s price began to decline, an unknown market participant started selling ETH and buying UST. UST was trading below its peg level, which allowed for profit.
Official Statements and Measures
Terraform Labs founder Do Kwon explained that the company removed 150 million UST from Curve to prepare for the launch of the 4pool. After that, they withdrew another 100 million UST “to reduce imbalance.”
Kwon emphasized that Terraform Labs was not involved in the 84 million UST operation. He also added that the company had no incentive to unpeg the stablecoin from the US dollar.
To stabilize the situation and strengthen UST’s price, the Luna Foundation Guard (LFG) provided loans to OTC firms—$750 million in BTC and $750 million in stablecoin.
“Traders will trade the capital on both sides of the market, helping to meet both objectives, ultimately supporting the LFG reserve pool’s parity (denominated in BTC) as market conditions gradually stabilize,” the organization stated.
Shortly after, the organization published its new Bitcoin address and noted that it would continue providing loans to market makers.
Continued Market Collapse
Despite these efforts, the market continued to collapse. Bitcoin, which began its decline on May 5, tested the $30,000 support level by May 10. The prices of most altcoins fell even more sharply. Panic spread.
As the crypto market continued to crash, UST again lost its peg to the US dollar. On the night of May 10, the price of the asset fell below $0.62.
The Block analyst Larry Cermak noted that Jump Crypto, Alameda Research, and other organizations supporting the Terra ecosystem allocated an additional $2 billion “to save UST.” However, in his opinion, the only way to preserve the asset was to make it fully collateralized.
On Wednesday, May 11, Terra USD once again lost its peg to the US dollar—its price plummeted below $0.23. The cryptocurrency LUNA, used to issue the stablecoin, fell by more than 80%.
Rescue Efforts and Further Decline
Sources from The Block reported LFG’s plans to raise $1 billion to stabilize the stablecoin’s price. According to the publication’s interlocutors, the organization sought funding from “some of the largest investment companies and market makers in the industry,” offering investors to buy LUNA at a 50% discount as part of the deal.
However, according to The Block Research analyst Mikko Honkasalo, LFG’s attempt to raise funds “failed.”
Researcher Hasu compared the project to a Ponzi scheme, stating that “UST is worse than BitConnect.”
On May 11, Do Kwon presented a plan to restore the price of the algorithmic stablecoin.
According to him, the necessary step before taking further measures was to absorb the supply of UST held by those wishing to exit the asset.
The plan involved accelerating the issuance of LUNA. According to the mechanism, 1 UST should be available for exchange at any time for $1 in LUNA. Kwon believed this “would allow the system to absorb UST faster.”
Amid market participants’ fears of hyperinflation, the price of LUNA collapsed below $1, while UST stabilized around $0.5. Due to the loss of confidence in the ecosystem, the price of the flagship project Anchor (ANC) token also plummeted.
Major South Korean crypto exchanges reacted to the sharp drop in LUNA’s price: Coinone suspended trading of the asset, while Korbit and Bithumb issued warnings to investors.
The cryptocurrency derivatives platform Binance Futures delisted LUNA perpetual contracts settled in the base asset.
Rumors and Speculation
Rumors surfaced that BlackRock and Citadel Securities borrowed 100,000 BTC from the Gemini exchange and swapped 25,000 BTC for UST. Allegedly, they contacted Do Kwon and said they planned to sell a large amount of Bitcoin, offering him to buy a significant amount of cryptocurrency at a discount for UST.
Then, BlackRock and Citadel allegedly dumped their assets, triggering the crash of UST, LUNA, and the entire market.
The theory suggests that “BlackRock and Citadel knew Anchor, holding a substantial amount of LUNA, was a Ponzi scheme. This collapse would lead to withdrawals exceeding Anchor’s capacity to repay, causing a massive sell-off of LUNA, de-pegging it from $1, and further market destruction. Subsequently, BlackRock and Citadel could buy Bitcoin at a low price to repay their loan and pocket the difference.”
IOHK head Charles Hoskinson circulated this theory, later deleting his tweet and noting that the rumors were unverified.
Gemini stated it did not loan 100,000 BTC to institutional counterparties.
BlackRock dismissed the rumors as “categorically false,” asserting it doesn’t trade the asset. Citadel also denied involvement with stablecoins, including Terra USD.
On May 12, with LUNA’s price around $0.05, Terraform Labs proposed several measures to restore the ecosystem. One initiative involved expanding the base pool of LUNA and increasing its issuance, supposedly to more quickly remove the necessary amount of UST from circulation.
Criticism of these measures erupted online, with some users arguing this would only hasten the ecosystem’s “death spiral,” leading to LUNA’s complete devaluation.
Larry Cermak suggested that Terraform Labs’ only solution was to abandon UST and focus on developing the main network, emphasizing that as the ecosystem grows, the project team must settle its stablecoin debts.
The Anchor community also prepared an “emergency proposal” to reduce the target yield rate on UST deposits to 4% per annum. Author Daniel Hong explained this step would halt the influx of additional UST into circulation.
By this time, Anchor’s fund outflow had reached nearly 9.5 billion UST.
Terra’s developers paused blockchain operations several times, citing the need to protect the network from potential “governance attacks” and to develop a “recovery plan” for the system.
Following the first pause, LUNA traded just above $0.01. On May 13, as the asset’s price plummeted to $0.00006, Binance delisted nearly all LUNA and UST trading pairs from its spot market, later resuming trading these assets in pairs with BUSD.
The “rescue” measures from Terraform Labs resulted in LUNA’s supply ballooning to an astronomical 6.5 trillion coins, further devaluing the project’s native token.
LUNA’s Echo
The massive volatility of LUNA caused issues with price feeds in the decentralized oracle network Chainlink, which many DeFi projects rely on for their operations.
The lending protocol Venus reported a loss of $13.5 million due to Chainlink’s oracle settings, which did not allow the display of LUNA’s price below $0.1.
In response, the Venus team temporarily disabled the protocol and then introduced proposal VIP-61 to set the collateral factor to zero for LUNA and UST markets.
A similar exploit was reported by the Blizz Finance protocol on the Avalanche blockchain.
Amid the widespread panic, even the most liquid centralized stablecoin, USDT by Tether, deviated from its peg. Interestingly, its competitor, USDC, remained largely unaffected.
The mass exodus of assets from Anchor, followed by the collapse of LUNA and UST, not only devastated Terra’s TVL but also significantly impacted the overall DeFi segment.
Future Prospects for Terra
Some market experts believe the Terra incident will have significant repercussions for the cryptocurrency market, regardless of the outcome. Blogger Dennis Porter noted that regulators might use the UST collapse as a prime example to advocate for comprehensive stablecoin regulation and the promotion of Central Bank Digital Currencies (CBDCs).
U.S. Treasury Secretary Janet Yellen stated that Terra USD’s de-pegging highlighted the necessity of creating a regulatory framework for stablecoins to minimize volatility.
Yoon Chang-Hyeon, a member of South Korea’s People Power Party, called for parliamentary hearings regarding the recent collapse of the Terra ecosystem.
Reportedly, three legal team members at Terraform Labs resigned following the UST and LUNA crash. Additionally, it was revealed that prominent South Korean law firm LKB & Partners is preparing to sue Do Kwon.
What’s Next for Terra?
The measures taken by the developers have clearly worsened the situation surrounding LUNA and UST, resulting in hyperinflation of the native token and a complete loss of community trust in the project and ecosystem.
In an effort to turn things around, Kwon proposed restarting the network with 1 billion tokens. Shortly after publishing this proposal, he expressed his sorrow over the harm his creation had caused to the community.
“I still believe that decentralized economies deserve decentralized money. However, it is clear that in its current form, UST will not become such money,” he wrote.
Kwon assured the community that neither he nor any related organizations had profited from the incident. The head of Terraform Labs also emphasized that he had not sold any LUNA or UST during the crisis.
The community proposed a hard fork and the issuance of a new token. The distribution of this new token would be based on a network snapshot taken before the market collapse.
The initiative also includes a new blockchain organization mechanism and the creation of a pool to retire the algorithmic stablecoin UST.
Proposed Solutions:
- Hard fork to TERRA2
- Snapshot of all holdings before the collapse trigger and distribution of new LUNA2 tokens to holders
- Creation of a new and improved chain with LUNA2 and UST2
- Establishment of a pool to repay the old UST peg
- Focus on building
Lionel🦁₿ (@CryptoLionel) tweeted on May 13, 2022, suggesting these steps.
Skepticism and Concerns
Binance CEO Changpeng Zhao questioned the viability of a Terra hard fork, suggesting that the new chain would hold no value. Zhao also inquired about the use of LFG’s Bitcoin reserves, which were intended to support UST.
On May 16, LFG representatives announced that their Bitcoin reserves were nearly depleted, with only 313 BTC remaining out of the 80,394 BTC held on May 7.
This revelation left many astonished that the massive Bitcoin interventions had not stabilized UST.
However, some saw a silver lining in the fact that Bitcoin had not crashed following the extensive sell-offs aimed at saving Terra.
On May 14, Ethereum co-founder Vitalik Buterin urged Terra to focus on compensating small investors, endorsing a suggestion by Twitter user PersianCapital.
A few days later, Do Kwon proposed a Terra hard fork, resulting in a new network and airdrop.
The new network would retain the name Terra with the LUNA token, while the original blockchain would become Terra Classic with the Luna Classic (LUNC) token.
The total issuance of LUNA would be 1 billion tokens, with a target staking reward (inflation) of 7%.
However, during a preliminary vote, the majority of the Terra community did not support the hard fork idea.
Risks Associated with Investing in Terra (LUNA and UST)
- Algorithmic Stability Concerns
TerraUSD (UST) is an algorithmic stablecoin designed to maintain its peg to the US dollar through an intricate mechanism involving the burning and minting of its sister token, LUNA. This mechanism has proven vulnerable to market conditions and coordinated attacks, leading to a loss of confidence and massive de-pegging incidents. Investors face significant risks from the inherent instability of algorithmic stablecoins, as seen in the collapse of UST.
- Market Volatility
The extreme volatility of LUNA, exacerbated by the algorithmic relationship with UST, poses a high risk for investors. Rapid and severe price fluctuations can lead to substantial losses, especially during periods of market panic or manipulation.
- Regulatory Uncertainty
Following the collapse of UST and LUNA, there has been increased scrutiny from regulators worldwide. For example, U.S. Treasury Secretary Janet Yellen has highlighted the need for regulatory frameworks to address the volatility of stablecoins. Potential new regulations could impact Terra’s operations, market value, and its ability to function as intended.
- Loss of Investor Confidence
The events leading to the massive devaluation of LUNA and UST have significantly eroded investor confidence in the Terra ecosystem. This loss of trust can lead to decreased investment, lower liquidity, and further downward pressure on token prices.
- Operational Risks
The management and operational decisions by Terraform Labs have come under heavy criticism, particularly regarding their handling of the crisis. The resignation of key legal team members and the firm’s ongoing legal battles suggest potential internal instability and governance issues, which can affect the project’s future.
- Technology Risks
The underlying technology of Terra, including its smart contracts and blockchain infrastructure, is subject to vulnerabilities and exploits. For instance, issues with the Chainlink oracle, which couldn’t display LUNA’s price below $0.1, led to significant losses for protocols relying on accurate price feeds.
- Economic Model and Hyperinflation
The economic model of Terra, particularly the response to crises involving massive token issuance, can lead to hyperinflation. The dramatic increase in LUNA’s supply to stabilize UST devalued the token, causing a hyperinflationary spiral that wiped out a significant portion of its value.
- Market Manipulation and Attack Risks
The Terra ecosystem has shown susceptibility to coordinated attacks and market manipulation. The speculative theory involving entities like BlackRock and Citadel, despite being denied, underscores the potential for large-scale manipulation that can devastate the ecosystem.
- Community and Ecosystem Development
The proposal to hard fork Terra and create a new token network has met with mixed reactions. While intended to restore confidence, such measures may fragment the community and lead to further instability. The future development and acceptance of the new network are uncertain, posing additional risks to investors.
- Legal and Regulatory Challenges
The potential legal actions against Terraform Labs and its executives, including lawsuits from major law firms and scrutiny from regulatory bodies, could result in significant financial and reputational damage. Legal battles can drain resources and divert focus from development, impacting the project’s viability and investor returns.
Conclusion
The collapse of Terra’s algorithmic stablecoin, UST, and its associated token, LUNA, marked a significant event in the cryptocurrency industry, shaking investor confidence and triggering widespread repercussions. The rapid de-pegging of UST from the US dollar and the subsequent crash of LUNA led to massive losses for users and institutional investors alike, reverberating across the broader DeFi ecosystem.
Despite efforts by Terraform Labs and the Luna Foundation Guard (LFG) to stabilize the situation through various measures, including significant capital injections and proposed hard forks, the market continued to spiral downward. Regulatory scrutiny intensified, with calls for stablecoin regulations echoing from prominent figures like U.S. Treasury Secretary Janet Yellen.
The crisis exposed vulnerabilities in Terra’s economic model and governance, raising concerns about algorithmic stablecoins’ reliability and the risks associated with decentralized finance projects. Operational missteps, technological challenges, and suspicions of market manipulation further exacerbated the situation, undermining trust in the ecosystem.
Looking ahead, the future of Terra remains uncertain. The community’s divided response to proposed solutions, such as hard forks and token swaps, reflects ongoing uncertainty and potential fragmentation. Regulatory actions and legal challenges could further impact Terra’s ability to recover and regain market trust.
Investors considering involvement in Terra (LUNA and UST) must carefully weigh the significant risks outlined, including algorithmic stability concerns, market volatility, regulatory uncertainties, and operational and legal risks. The events surrounding Terra serve as a stark reminder of the high stakes and complexities involved in investing in emerging technologies and decentralized financial systems.
Ultimately, the fallout from Terra’s collapse underscores the need for rigorous risk assessment and regulatory oversight in the cryptocurrency space, as stakeholders navigate the path towards a more stable and resilient digital economy.
FAQ
- What caused the collapse of Terra LUNA?
The collapse of Terra LUNA was primarily triggered by the rapid de-pegging of its algorithmic stablecoin, UST, from the US dollar. This instability led to a cascade of sell-offs, significantly devaluing the LUNA token and eroding investor confidence in the Terra ecosystem.
- What is UST and how does it work?
UST is an algorithmic stablecoin designed to maintain its peg to the US dollar through a complex mechanism involving its sister token, LUNA. When UST deviates from its peg, mechanisms like burning or minting LUNA tokens are employed to stabilize its price. However, these mechanisms proved ineffective during the crisis.
- How did the collapse affect the cryptocurrency market?
The collapse of Terra had widespread repercussions across the cryptocurrency market. It raised concerns about the reliability of algorithmic stablecoins, led to significant losses for investors and institutions, and triggered regulatory scrutiny. Other DeFi projects relying on stablecoin liquidity also faced challenges.
- What were the regulatory responses to the Terra collapse?
Following the collapse, there were calls for increased regulation of stablecoins. US Treasury Secretary Janet Yellen highlighted the need for stablecoin regulation to minimize volatility. Regulatory bodies worldwide began to scrutinize algorithmic stablecoins and their impact on financial stability.
- What were the efforts made to stabilize UST and LUNA?
Terraform Labs and the Luna Foundation Guard (LFG) undertook various measures to stabilize UST and LUNA, including injecting significant capital into the market, proposing hard forks, and attempting to restore confidence through community initiatives. However, these efforts were met with mixed results amid ongoing market turmoil.
- How did market manipulation play a role in the collapse?
There were suspicions of market manipulation during the Terra collapse, including coordinated sell-offs and suspicious transactions involving significant amounts of UST and other cryptocurrencies. These activities contributed to the downward spiral of UST and LUNA prices.
- What were the technological challenges faced by Terra during the crisis?
Terra encountered technical challenges, such as issues with price feeds on decentralized oracle networks like Chainlink, which affected the accurate pricing of LUNA. These challenges further exacerbated the crisis and undermined confidence in the ecosystem.
- What are the long-term implications for Terra and its investors?
The collapse of Terra has raised long-term implications for investors, including heightened risks associated with investing in algorithmic stablecoins, ongoing regulatory uncertainties, and potential legal repercussions. The future development and adoption of Terra’s proposed solutions remain uncertain, impacting investor sentiment and market dynamics.
- What should potential investors consider before investing in Terra?
Potential investors should carefully assess the risks associated with Terra, including algorithmic stability concerns, market volatility, regulatory developments, operational risks, and technological vulnerabilities. Conducting thorough due diligence and staying informed about ongoing developments in the cryptocurrency space are crucial steps.
- How can Terra recover from the collapse?
Recovery for Terra will depend on restoring investor confidence through transparent governance, effective risk management, and potentially restructuring its economic model. Community support and regulatory compliance will also play key roles in Terra’s path to recovery and rebuilding trust in its ecosystem.
