With a guaranteed annual return of 18–20%, TerraUSD (UST) saw a rapid rise to the top of stablecoins. However, the algorithmic approach of the project ended in a collapse of the entire Terra–Luna ecosystem and the destruction of $60 billion in market value. A post mortem wrapup.
Stablecoins, most often in the form of dollar-pegged tokens, have established themselves over the past few years as essential pillars in the world of decentralized finance (DeFi). They are included in the most traded cryptocurrency pairs and are considered a safe haven against volatile cryptocurrencies due to their peg to fiat currency. Usually, stablecoins are managed by centrally-operated companies that back new tokens with dollar deposits and liquid financial instruments.
Algorithmic stablecoins use a different approach. In this case, an algorithm/protocol acts as a central bank and is responsible for the stability of the peg. Unlike fully or over-collateralized stablecoins, where the peg/collateral is provided by the cryptoassets themselves, the peg/collateral is provided by the protocol’s own token, whose price is subject to supply and demand. In theory, the minting and burning of the protocol’s own tokens should be able to offset any inflationary or deflationary tendencies of the stablecoin in question. In practice, as evidenced by the Luna example, such models only work with a constant increase in demand, and in the reverse case, they are very vulnerable to disproportionate investor redemptions.
The interaction between LUNA and UST
Terra used a dual token system to peg its value to the dollar. On the one hand, the LUNA token was used to pay network fees, participate in governance votes, take part in the consensus process (PoS), and mint stablecoins. On the other hand, the dollar-pegged stablecoin TerraUSD (UST) was meant to be backed by a unique seigniorage system.
Terra’s system used a corresponding token minting and burning mechanism in conjunction with the platform token LUNA. To create new stablecoins in the form of UST, the same dollar amount is burned in LUNA. If UST is returned, LUNA tokens are created for the same dollar amount, which then can then be sold in the market. So one dollar worth of LUNA tokens should always be exchanged for one UST and vice versa. This created an arbitrage opportunity for market participants if the TerraUSD exchange rate deviated from 1 dollar. The mechanism also exerted a deflationary pressure on LUNA if UST gained adoption.
Anchor as a pillar of the Terra Luna ecosystem
To jumpstart sluggish demand for UST, Terra’s founding team (Terraform Labs) developed the Anchor DeFi protocol in 2021. Anchor was a fixed-rate yield-bearing savings protocol—similar to Ethereum-based Aave—that guaranteed 18-20% annual returns on UST deposits. Because money market rates and staking returns fluctuated with market conditions, the protocol set up a reserve pool to be tapped into during times of weak markets, allowing it to continue to offer high returns.
The Anchor Protocol defined a money market between a lender earning stable returns on its stablecoins, and a borrower wanting to borrow Stablecoins against collateral. Along with a few other DeFi applications on its own Terra Blockchain, Anchor provided the lion’s share of demand for TerraUSD (UST). Thanks to the attractive and artificially high interest saving rate of 20%, which was financed in UST and therefore potentially with newly minted Luna tokens, it was initially possible to maintain a constant demand for UST, which was able to bridge the vulnerabilities of the entire system over a longer period of time.
On May 8, 2022, the UST stablecoin showed first signs of weakness and briefly fell to 98 cents. In response, some leveraged UST holders and liquidity providers (LPs) gradually liquidated their positions to hedge against a collapse. But the withdrawals from the largest Terra DeFi product also had a negative impact on confidence in UST. After a few hours, leveraged position liquidations and panic selling drove the UST price to 60 cents – nearly 40% lower than the planned dollar peg.
Due to the high volatility of the UST token, the spreads for exchanging against LUNA increased, causing the binding mechanism to ultimately fail. This is where the Luna Foundation Guard (LFG) came into play; a non–profit organization that manages Bitcoin reserves worth $4 billion for binding retention.
2/ Consistent with its non-profit mission & focus on the health of the Terra ecosystem, beginning on May 8, when the price of $UST began to drop substantially below one dollar, the Foundation began converting this reserve to $UST.
— LFG | Luna Foundation Guard (@LFG_org) May 16, 2022
Despite the liquidation of the entire LFG reserve pool, UST’s implosion could not be stopped. Unsums of UST were exchanged for newly created LUNA under the seignorage system and then sold on the open market – the death spiral of the ecosystem was in full swing. Combined, UST and LUNA had a market capitalization of $60 billion, which evaporated into less than $1 billion within days. The process was only stopped with the deactivation of the entire Terra blockchain.
Terra founder prefers arrogance over solutions
South Korean Do Kwon, is among the main developers of the Terra Blockchain and co-founder of Singapore-based Terraform Labs. The company had $32 million in seed capital, with backing from Binance, Arrington XRP and Polychain Capital, among others.
Do Kwon responded to criticisms of Terra’s ecosystem and its vulnerability on Twitter. The founder’s response to critics mostly consisted of condescending comments instead of addressing the often-cited weaknesses of the protocol. One example of this is a Twitter message from November 2021 describing how a malicious actor could trigger a liquidation cascade with around one billion USD. Instead of addressing the criticism, Kwon challenged all billionaires to follow Raynolds’ plan.
Probably the most retarded thread ive read this decade.
Silence is a perfectly acceptable option if stupid.
Billionaires in my following, go ahead, see what happens https://t.co/wtt9OhX4kg
— Do Kwon ? (@stablekwon) November 28, 2021
This Twitter thread actually pointed to critical errors in the Seignorage system that eventually led to the collapse of the Terra-Luna ecosystem. Even on May 8th in the midst of the first loss of the peg, Kwon only labeled skeptics as financially weak and assured his followers that a long-term UST decoupling was impossible. Thus, it seems clear that the unprofessional behavior of the Terra founder also had a negative impact on key decisions made by the Luna Foundation and its capital providers, particularly on initial rescue attempts made by prominent venture capitalists.
This is a setback for algorithmic stablecoins and the entire DeFi sector
In the wake of the collapse, the founding team decided to rebuild the entire Terra ecosystem without the algorithmic stablecoin UST on a forked blockchain. As a result of the break–in, the founding team decided to rebuild the entire Terra ecosystem on a separate blockchain (fork) without the algorithmic stablecoin UST.
Even if the rumors are true that a targeted attack by hedge funds led to the collapse of the Terra ecosystem, that ultimately just means that the algorithmic-backed stablecoin model is not sustainable.
Overall, it must be noted that the loss of billions of dollars has caused a lot of trust to be lost in the still young DeFi world. Despite the warning signs that have been present for some time, many investors have lost considerable sums of money. The concept of fractionally collateralized stablecoins is likely to have come to an early end with Terra. UST follows in the footsteps of numerous failed attempts at under-collateralized stablecoins, but on a grand scale.
The fractional reserve system of banks has always been shown to contain unmanageable risks in the traditional financial world, and this is no different in a blockchain-based environment. Ultimately, the same principles apply in the world of decentralized finance as in the old world. First-class collateral is one of the important pillars of financial stability.
If you want to see the silver lining, it must be said that the $150 billion DeFi sector at the time of the Terra meltdown was able to weather the implosion without major collateral damage. This reality-based stress test shows the resilience of a 24/7 blockchain-based financial system.