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. The phenomenon must have seemed like a celestial joke to holders of the LUNA cryptocurrency. The Terra blockchain’s native asset had dropped from $80 to below $1 per token days earlier. This resulted in a $40 billion loss in value. Gox 2.0.
The darkest hour in crypto’s history since the Mt. Gox exchange in 2014; LUNA’s collapse has eclipsed BitConnect’s collapse and the March 2020 market crash.
“I believe that the core issue that drove Terra to its initial success was also what led to it to a catastrophic fail,” ventures Victor Young at Analog. “Accordingly to Terra’s whitepaper [founder] Do Kwon desired a stablecoin infrastructure better than Bitcoin for payments, and strong enough to rival Ethereum’s dApp ecosystem. This meant that a stablecoin product could be used in traditional markets to compete with fiat currencies. Unfortunately, transparency was lacking throughout the entire project.
According to the old saying, you can only find out who has been naked swimming when the tide goes out. It turned out that many people who should have known better were found bathing in the buff as the Terra ecosystem receded. Investors of all types were there, from influencers to hedge funds, to use the lingo, rekt.
However, the cryptocurrency industry is no stranger to reinventing itself. In the wake of Terra’s collapse, many leading figures have pledged to learn from their mistakes and prevent it from happening again. The failure of Terra’s algorithmic stablecoin UST triggered a “death spiral”, which saw the dollar-pegged asset drop to just cents, and the LUNA token lose 99 percent of its value.
Many within the crypto industry believe that the implosion of the project offers an opportunity to reduce risk and create more resilient systems that can withstand extreme economic shocks. For regulators and policymakers who are driven by market stability and consumer protection mandates, this is unlikely to be enough to stop crypto from becoming a problem.
The fact that a synthetic derivative can be called a stablecoin is a sign of the lack of an industry standard to ensure stability. This will likely attract further criticism from policymakers who seek to regulate stablecoins. Stablecoin refers to stability via asset-backed fiat reserves or low-risk fiat. This is in contrast to synthetic fiat pegs managed by algorithms that are opaque to the (highly risk) underlying assets.
“To Terra’s vocal critics – you were correct and we were wrong,” wrote, a distraught Delphi Digital investment arm that lost $10 million. “We understood the risk of the algorithmic modeling upfront and tried to be transparent about them throughout. However, it’s clear that we miscalculated these risks.”
Preston Byrne is a partner at Anderson Kill and one of the most respected legal beagles . He called out algo-stablecoins in 2018, with Basecoin, Base Protocol and Terra with a scathing conclusion: “This is an exceedingly poor idea.”
How it All Started
Algorithmic stablecoins, which are dollar-pegged cryptoassets that don’t have fiat backing them, have a long and troubled history. Due to the difficulty of creating a token capable of holding a death grip of 1 USD under extreme sell pressure, every attempt to create an “algo stability” has failed.
“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 something different. And it was for a long while. Twelve months ago, the LUNA token traded for less than $5. But as the crypto bull markets kicked into high gear, LUNA soared and raised the Total Value Locked on the network to billions. LUNA’s peak price was $116 in April 2022. This provided huge returns to its early backers.
Everybody, from HNW individuals to dads FOMO’d into Terra. The UST stablecoin is regarded as a low risk option for savers. Anchor protocol’s UST paid out a generous 20% yield, and the collateral was the volatile LUNA token.
Alkemi Network co-founder Brian Mahoney says it all in his Terra post-mortem: “It is unfortunate UST was mislabeled a stabilizecoin as its growth fueled by greed and excessive leverage and a massive cash burned financing its nearly 20% risk-free rate.”
How it ended
Experienced crypto observers will confirm that the long-term success or failure of a project depends on its code quality and sustainability. Terra was capable of developing, but the network incentives seemed dubious at best. Even last year, critics began to discuss flaws in UST’s algorithmic model. highlighted possible attack vectors.
The prophecy was fulfilled when Terra network fell to the kind of attack it had been predicting. Although the jury isn’t sure if it was a coordinated attack of rich whales or a single wolf, what is certain is that UST was an accident waiting for its economic model to come true.
The dollar peg fell to $0.98 after a monied player sold off UST on Curve protocol. But that was just the beginning. Do Kwon, Terra’s figurehead, was not known for being humble. dismissed the incident as a minor bump in the road, but it was already a fatal blow. Over the next five days, UST & LUNA began a race to get to the bottom. The UST peg was not restored by even the sale of Luna Foundation’s large Bitcoin reserves.
“The main reason Luna collapsed was due to the complexity of managing the UST price across centralized and uncentralized trading venues,” James Taylor, CeDeFi exchange Unizen, states that “The attacker cleverly chose Curve to attack the protocol that inflicted the most damage and incited panic.”
ParallelChain Lab CEO Ian Huang said that the Terra LUNA/UST crash was shocking but not unexpected. “All algorithmic stablecoins have inherent points of failure because they are mainly sustained through the arbitrage system, assumed-normal market conditions, and primarily supported by the arbitrage. Terra’s flawed tokenomic model, along with a lack of various utilities supporting the ecosystem were the straw that broke the camel’s back. This resulted in an easy loss of confidence and aggressive panic selling.
“When hundreds of thousands lose billions of dollars collectively through a DeFi app that is promoted as a safe savings account and not as a risk-on investments, by some of most respected names in crypto, regulation most certainly on the way,” says Kene Ezejioye, Millicent.
“Although this may surprise many, there are key industry players like FTX CEO Sam Bankman Fried and the U.K’s Financial Conduct Authority, who know that smart regulation might just the only thing that can save cryptocurrency from itself and catapult it into mainstream,” says Ezeji Okoye.
While UST and LUNA holders were the most affected by the meltdown, macro forces played a greater role in the chain reaction.
“We are witnessing a domino effect wherein the global supply chain crisis contributes to high inflation, and in turn the high volatility crypto market,” says Benjamin Bilski CEO of German fintech NAGA.
Brian Mahoney, Alkemi’s CEO, sees reason for optimism. He predicts, “Despite the shadow cast upon the stablecoin sector of the market,” that the sector will emerge stronger. I look forward to continued contributions from thoughtful and reputable stablecoin projects like USDC, DAI and FRAX in order to bring stability to crypto. These stablecoins are based on solid fundamentals and will be true stablecoins.
“UST’s devaluation has had significant effects on overall sentiment, and we are seeing a decreasing number of monthly active DeFi user that could threaten existing businesses models,” says Lucas Mateu (Co-founder and CEO of vent Finance).
Cult of the Strong Leader
Terra’s flawed algorithmic stablecoin has not been the only target of criticism. Do Kwon, a hubristic cryptocurrency investor, has also been under fire.
Analog’s Victor Young recalls that Do Kwon “continued to silence critics who pointed out flaws within the stablecoin’s algorithm,” and “He even mocked economists for being poor.” The fact that the stablecoin wasn’t tied to any non-crypto collateral is a key part of any discussion about what caused UST. It used a pairwise token system in which users swapped Luna for UST and vice versa to guarantee a price of $1. This relied on a weak consensus mechanism that was manipulative.
Market experts predict further downside and a flight towards crypto market stalwarts like BTC.
Ben Caselin is Head of Research & Strategy at AAX. “We may see a major shift in favor of Bitcoin and Ethereum. While turbulence might drag for weeks. A renewed focus on quality, decentralized network over frivolous coin and risky experiments in the market can be incredibly positive for the asset that started it all: bitcoin.
The Great Rebuild Is Underway
Terra’s collapse was a devastating blow to the community of Terra developers, users, platforms, and applications. Some people have chosen to leave the failing ecosystem and open a new business, Cosmos, which is a community-centric network, that has made overtures for Terra’s devs.
There are very few options for Do Kwon, his team and close friends. One option is to rebuild Terra completely from scratch, but without the ticking clock of an algorithmic stabilizecoin. It is not clear if this is possible or whether the market and ecosystem will be able to trust a rebuild.