Terra’s Demise: what to see from the rise and fall of UST
Terra will be remembered as the poster child for a cryptocurrency bull run in 2020.
It started with a humble experimental stablecoin. But in the space of a year, Terra went from one of the best performing assets in this cycle to the most spectacular crash the major crypto asset has ever seen. The repercussions of its failure will reverberate across the industry for years to come — perceptions of DeFi and decentralized stablecoins could be permanently damaged. Its story serves as an educational parable about misdirection, excess and stupidity.
Terraform Labs, the company behind Terra, started out in 2018 as a decentralized algorithmic stablecoin. Terra’s original vision was to create a set of stablecoins pegged to major currencies to reduce e-commerce transaction costs and facilitate real-time payments. The two founders are Do Kwon and Daniel Shin, both American-educated Korean serial entrepreneurs. Daniel Shin was a former co-founder of TMON, one of the largest e-commerce companies in Korea – he later parted ways from Terraform Labs to run Chai, a Korean merchant payment platform powered by Terra.
In the early days, Terra only facilitated e-commerce payments in South Korea, and almost all payments were made through Chai. But after DeFi exploded in the summer of 2020, Do Kwon had an insight: By extending the Terra blockchain to support smart contracts, he could create a native DeFi ecosystem to increase the popularity of the UST-centric Terra stablecoin Adoption, the stablecoin is pegged to the U.S. dollar. (Prior to this, the largest stablecoin on Terra was KRT, which was pegged to the Korean won.)
This strategy has been a huge success. Terra has exploded in popularity in 2021 and is one of the best performing assets in 2021, appreciating 145x from $0.63 to $91.38 for the year. Terra flips Solana into the most valuable L1 alternative after Ethereum starting in March 2022.
At the heart of this rapid growth is Anchor, the leading Terra protocol built by Terraform Labs. Dragonfly Capital was an investor in Anchor’s seed round. It was originally conceived as a simple idea – it is a money market that accepts UST and yield-generating assets (usually liquid equity derivatives like stETH). Since collateralized derivatives passively generate yield, this yield is captured by the protocol and used to subsidize the prevailing interest rate paid to depositors.
The most important (and controversial) feature of Anchor is that the protocol determines a fixed target rate of return for depositors instead of paying market rates. Since its inception, the ratio has been set at around 20%. To achieve this benefit, Anchor pays additional interest from UST’s on-chain reserves, capitalized by Terraform Labs.
In the early days of Anchor, this was largely sustainable as the prevailing interest rates in DeFi were high. But Anchor refused to change its target rate as broader DeFi yields fell in the summer of 2021. This makes Anchor’s 20% guaranteed yield increasingly attractive.
Over time, Anchor’s 20% stable yield is many times higher than the prevailing stablecoin yield, which is generally stable below 2%. Deposits on Anchor have exploded, disconnected from borrowing. It ultimately makes Anchor the largest single lending protocol in all DeFi by Total Value Locked (TVL).
A small ecosystem of new types of banks emerged that simply used Anchor as their backend, offering their clients a nominal 20% yield. We’re even starting to see Anchor SPV, which takes dollars from family offices and sells 20% yields.
More and more UST is starting to be minted just to deposit Anchor for the UST yield. At its peak, Anchor held more than $14 billion in UST and was the receiver of nearly every existing UST. It single-handedly made UST the third largest stablecoin in the world.
But is it sustainable?
Clearly, a 20% yield on UST over $10 billion (over $2 billion in annual interest payments) cannot be offered using only the interest paid by borrowers. On-chain revenue reserves need to pay the difference. But as UST deposits grow, yield reserves are rapidly drying up.
In February 2022, in the face of dwindling on-chain reserves, Do Kwon was forced to quickly fund the reserves with $450 million in UST.
This dynamic is the ultimate reason for the rise of UST.
Anchor is the “cancer” of Terra and its dizzying growth hub. It needs to be fed, and through its voracious appetite, UST is the fastest growing stablecoin in the entire industry.
but why? If it’s clearly not sustainable, why do it? Why didn’t they stop sooner?
The argument behind Anchor’s gains is simple: Anchor is critical to the wider adoption of Terra and its core stablecoin, UST. The reflexive nature of UST growth and the LUNA price attracts new developers and projects to Terra, strengthening the cycle. Some argue that the benefits are simply the customer acquisition costs that must be paid before UST becomes the dominant stablecoin in cryptocurrencies.
mXU6QSjyvBAje4vvm0aoxJlubRQRDLw0cya7wxcy.pngAnchor A commenter on the governance forum. Source: Anchor Protocol
While we, like many others, have publicly commented on the unsustainability of UST and Terra, Terra has brushed aside all challenges. Do Kwon developed a cult of personality around himself, openly attacking opponents and refuting claims that were unsustainable.
Do Kwon publicly bet $1 million on Terra’s future solvency with Algod, who publicly denounced Terra as a Ponzi scheme. Do Kwon and other critics made public bets totaling $11 million. Source: Twitter
The Terra community now relies on Anchor. Abandoning it is not an option. Additionally, the market cap of the LUNA that ultimately “backs” UST is more than double the value of the outstanding UST supply. So eventually it was argued that even at this level of growth, UST could be safely over-collateralized.
It was originally like this. But to understand how everything finally unravels, one must understand the second aspect of the UST: how it is created and redeemed.
Terra can be thought of as a central bank: it takes on liabilities in the form of UST and owns assets in the form of LUNA, the native token of its blockchain. The central bank has only one task: to keep UST always trading at $1. It does this by essentially “making a market” in UST – it always trades 1 UST for $1 worth of LUNA (it uses an on-chain oracle to monitor its price).
This means that if the price of UST is $0.99, arbitrageurs can burn their UST with $1 worth of LUNA. If the price of UST is $1.01, arbitrageurs can mint additional UST with only $1 worth of LUNA. Both of these mechanisms should lead to a rapid return of UST to the peg.
In a sense, the value of all outstanding UST is secured by all LUNA held by the protocol. (Terra also has an on-chain reserve, which is collected by charging a small transaction fee on transfers, but this is minimal.)
As UST supply expands, there are growing concerns about the systemic risks of UST expansion. To allay these concerns, Terraform Labs has formed a new nonprofit called the Luna Foundation Guard (LFG) to support UST hooks. Its most notable members include Jump Capital, the venture capital arm of Jump Trading, and Delphi Digital. Jump is one of the most profitable market makers in all of the crypto space, with profits rumored to be in the billions last year, much of which came from massive bets on the Terra ecosystem.
LFG raised a $1 billion funding round, led by Jump Capital and Three Arrows Capital, to build a Bitcoin reserve to diversify UST support away from LUNA alone. This is in addition to the initial funding of 72 million LUNA, which at the time had a notional value of over $5 billion.
LFG has publicly purchased nearly $3 billion worth of BTC, with the goal of buying up to $10 billion in BTC, becoming one of the largest known BTC holders in existence, all to back the UST reserve.
So the reserve now consists of a large amount of LUNA as well as LFG’s BTC reserve. The Terra community fully believes that its central bank is now deep-pocketed and unbreakable.
But at the beginning of the second quarter, the ratio of LUNA to UST market capitalization fell rapidly as inflation concerns, risk assets, and the crypto market began to sell off.
This decline reached an inflection point on May 9. In response to a larger macro sell-off, some large whales pulled large positions from Anchor and dumped their UST via UST’s largest on-chain DEX -Curve. The magnitude of these sales (hundreds of millions of dollars in quick succession) has detached UST from its peg.
This caused panic. More and more Anchor users are starting to withdraw and sell their UST, exchange it for LUNA and sell LUNA for cash. LUNA fell from $22 billion to $11 billion in a matter of hours, losing 50% of its market value and surpassing the 100% mortgage threshold.
UST is now suddenly under-collateralized.
The market reacted violently. Anchor depositors scrambled to exit before UST and Anchor were fully burned. A full-scale bank run ensued. This sell-off spree led to a dramatic decoupling and a massive push down on UST.
Anchor’s total deposits plummeted in May as users rushed to withdraw.
LFG owns billions of dollars in LUNA and BTC, desperately trying to buy UST that is being sold, but cannot stop the sell-off. When on-chain detectives discovered that LFG had moved $1.4B of BTC holdings to Binance, the entire market was mired in fear of BTC being sold by the market into an already chaotic environment. Finally, as many have warned, UST is not diversifying at all — the correlation of crypto assets during panic times has reached 1, and BTC’s slump has caused LUNA to fall further.
Do Kwon and the Terra community anticipate that it will only be a matter of time before the hook is restored. Many believe that the sheer amount of capital backing LFG — billions of dollars in BTC and LUNA, plus vested interests in Jump Trading, Three Arrows Capital, and others — makes Terra too big to fail.
But over the next few hours and days, the UST peg gradually dropped along with the LUNA price.
There were rumors of huge margin calls, as well as funds and market makers exposed to LUNA and UST having to sell. The entire market fell in unison.
As more and more USTs are redeemed for LUNA, in order to satisfy all the redemptions, the LUNA has to be printed at an increasing rate. Initially, LUNA had a daily cap on its minting rate (enough to redeem ~$290 million per day), but to clear the backlog, validators voted to release this cap and speed up minting. But the market couldn’t digest the sell-off. Terra’s algorithmic issuance mechanism puts it into a vortex of hyperinflation, like a third world country stubbornly printing devalued currency to pay off its debtors.
By the end of day 3, the supply of LUNA had exploded from 345 million to 6.5 trillion, a supply expansion of approximately 18,840 times. By May 12, LUNA was delisted from all major exchanges, falling from over $60 to less than 0.1 cent. The Terra blockchain was halted because the cost of a governance attack had dropped so low that for just a few million dollars, anyone could take over the blockchain and wreak havoc.
Terra completely collapsed.
Terra is now in the process of trying to restructure itself. But Terra’s debacle completely destroyed the crypto market. Bitcoin is down 20%, and most altcoins are down 50% or more in a chaotic week. Tens of billions of dollars in paper wealth evaporated. Countless retail investors have lost their savings, funds that made big bets on Terra are in trouble, and developers building on the blockchain are now looking for new places to go.
Sadly, the end of this saga is predictable.
For now, the dust has settled. But two last questions remain: First, what can Terra do differently? Second, what are the long-term consequences of Terra’s failure?
Terra’s end was unnecessarily disruptive, even considering its catastrophic failure. According to rumors, LFG still holds over $1 billion in BTC unspent and is still sending LUNA into hyperinflation hurting LUNA holders and UST holders alike. At the end of the day, Terra is still a Layer 1 blockchain with an emerging ecosystem. As a pure blockchain, it has potential “enterprise value”. But after the UST collapsed, the system was suddenly saddled with massive bad debts. When a central bank’s liabilities exceed its assets, there is only one responsible thing to do: default on the debt and negotiate with creditors.
If Terra blockchain redemptions were suspended and Terra negotiated a repayment plan for UST holders, the blockchain might survive and UST holders could receive some compensation from their holdings. But instead, they did nothing — LUNA over-inflated and lost all purchasing power, rendering the blockchain itself worthless. There is now talk of restarting a new chain from scratch and airdropping to previous UST holders before a bank run.
But the main sin behind all Terra is ultimately Anchor. Anchor effectively turned itself into a Ponzi scheme by guaranteeing a year-round 20% APY during yield slumps. UST has little exogenous use outside of Anchor deposits. This means that the main value proposition of LUNA is as follows: buy LUNA to mint UST, deposit it in Anchor, earn interest in the form of other UST. LUNA was the ticket to the game, and since UST never achieved its ultimate goal—widespread adoption as the dominant stablecoin—the game ended in the only way it could.
This leaves us with one final question – what are the wider consequences of Terra’s failure?
Most obviously, “seigniorage stake” algorithmic stablecoins like UST will no longer be valued. The possibility of a stablecoin death spiral has long been known since the publication of the original algorithmic stablecoin Basis white paper. But Terra’s failure has burned it into the collective memory of cryptocurrencies. Every major algorithmic stablecoin has either failed outright or lost its value significantly in the last week.
We ran experiments on the largest scale imaginable. Terra’s debacle could be the death knell for seigniorage stablecoins.
The second consequence of Terra’s failure is the reinvigoration of regulation. Stablecoin and DeFi regulation is likely to come quickly and more punitively than ever. The last time we saw such a horrific public rout of a major crypto asset was the 2018 debacle of BitConnect, which was effectively a Ponzi scheme, whose promoters have since been indicted by the SEC. For a failure of this magnitude, regulatory attention must be drawn. We’ve seen Janet Yellen calling for regulation of stablecoins, as well as congressional hearings on the risks of DeFi.
Ultimately, Terra’s debacle is ultimately a story of megalomania, and the stupidity of growing at any cost. Taking risks and participating in open innovation is at the heart of entrepreneurship and what DeFi is all about. But with great freedom comes great responsibility, and when that responsibility is ignored, we all pay a price.