May 15, 2022

The Luna/Terra Collapse: Why and How It Happened? What Should We Expect Next? (#99 - 14 May 2022)

By Henri Arslanian • Issue #93 • View online

Dear Friends,

This past week will be one that will be talked about for years in the history of crypto, as the crypto industry had its own Lehman Brothers moment with the collapse of Luna and Terra.

In this issue of my newsletter, I explain the background of Luna and Terra, how Terra’s UST stablecoin worked, how the crash took place, and, most importantly, what consequences we should expect moving forward.

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Here we go!

An important event took place beginning last weekend when the algorithmic stablecoin Terra, which is supposed to be pegged to $1, fell as low as $0.10 in what can only be described as a crypto “bank run.”

In order to properly understand what happened, it’s important to understand the type of stablecoin Terra is and how it works.

By way of background, there are 3 kinds of stablecoins:

Stablecoins that are backed by fiat and are regulated (e.g. USDC)
Stablecoins that are backed by fiat but are not regulated (e.g. USDT)
Stablecoins that are algorithmically “backed” (e.g. UST)

I am grossly oversimplifying as there are a number of nuances from the type of assets held to the type of regulation but let’s put that aside for now. Terra falls into the last category of algorithmically backed stablecoins.

Algorithmic stablecoins are nothing new, as they have been around for quite some time.

Basis was one example of a non-collateralised algorithmic stablecoin before being shut down after running afoul of U.S. securities regulations, as bonds would be issued when it was trading for less than $1, and these were considered securities.

Terra’s approach was slightly different, as it introduced, based on a whitepaper issued in April 2019, a model in which Terra stablecoins are supposed to be backed by Luna, another cryptocurrency, instead of being backed by fiat currency.

Using a combination of open market arbitrage incentives and decentralised oracle voting, the Terra protocol basically creates stablecoins that aim to track the price of any fiat currency.

The Terra protocol runs on a proof-of-stake blockchain, in which miners need to stake the native cryptocurrency, Luna, to mine Terra transactions.

The protocol has two main types of tokens:

Luna: The Terra protocol’s native staking token that is supposed to absorb the price volatility of Terra. Luna is used for governance and in mining, and users stake Luna to validators who record and verify transactions on the blockchain in exchange for rewards from transaction fees.

Terra: These are supposed to be stablecoins that track the price of fiat currencies, with users minting new Terra by burning Luna. Stablecoins in the Terra ecosystem are generally named for their fiat counterparts, with the U.S. dollar stablecoin called TerraUSD, or UST.

Luna and Terra are intertwined due to a process of expansion and contraction.

Let’s start with expansion. When the price of Terra is high relative to its peg, supply is too small and demand too high, so the protocol incentivises users to burn Luna and mint Terra.

The new supply of Terra makes its pool larger, balancing supply with demand. Users mint more Terra from burned Luna until Terra reaches its target price, and the Luna pool gets smaller in the process, increasing the price of Luna.

For example, if 1 UST is trading at 1.01 USD, users can trade 1 USD of Luna for 1 UST. The market burns 1 USD of Luna and mints 1 UST. Users can then sell their 1 UST for 1.01 USD, profiting .01 USD through arbitrage, adding to the UST pool. This arbitrage continues until the UST price falls back to match the price of USD, maintaining Terra’s peg.

The process is the opposite in the context of a contraction.

When the price of Terra is too low relative to its peg, supply is too large and demand too low. The protocol incentivises users to burn Terra and mint Luna, and the decrease in Terra’s supply causes scarcity, so the price of Terra increases. More Luna is minted from burned Terra until Terra reaches its target price, and the Luna pool increases and lowers in price.

For example, if 1 UST is trading at .99 USD, users can buy 1 UST for .99 USD. Users can then trade 1 UST for 1 USD of Luna. The swap burns 1 UST and mints 1 USD of Luna. Users profit .01 UST from the swap. This arbitrage continues, and UST is burned to mint Luna until the price of UST rises back to 1 USD.

In recent months, Terra had also looked at diversifying its assets and had bought Bitcoin. The goal was to have TerraUSD be backed by other assets than just Luna.

Terra and Luna had many vocal supporters.

Terraform Labs, the company behind the project, assembled an impressive roster of notable VCs and investors over the years, including BlockTower Capital, Delphi Digital, Galaxy Digital, Hashed, Lightspeed Ventures, Pantera Capital and Parafi Capital, just to name a few.

Many large trading firms, from Jump to Three Arrows Capital, were also big proponents.

As was Mike Novogratz of Galaxy Investment Partners (and former co-founder of Fortress Investment Group), who even went so far as to get a tattoo of Luna!

And the project was largely successful.

Just a few weeks ago UST’s market cap reached nearly $18 billion, flipping Binance’s stablecoin (BUSD) and emerging as the third most circulated stablecoin in the crypto ecosystem.

A large part of UST’s popularity could be attributed to Terra’s Anchor protocol, which gave users around 20% interest, a very attractive rate indeed.

But what happened in recent days is that it turned out that this mechanism didn’t work as planned, culminating in the collapse of Luna.

One scenario is that this was a very deliberate attack. Whilst details are not known yet, it seems that traders started selling UST and shorted Bitcoin (and perhaps Luna). This was done over a weekend when liquidity was thin and overall markets were in decline. Proponents of this scenario believe that whoever did this was likely someone with good knowledge and experience in crypto markets and crypto trading who patiently waited for the perfect conditions to execute this trade.

What this trader did was not necessarily illegal. He just spotted a vulnerability in the design of the Terra and Luna mechanism and tried to take advantage of it. It can be argued that this is somewhat similar to George Soros’s famous attack on the British Pound in 1992.

Others believe in a different scenario that there was no malicious attack. Such a collapse was meant to happen due to the flawed design of the Luna ecosystem and the market conditions created a perfect storm.

Whilst it is too early to tell at this stage, this will be a topic that will be analysed by market commentators over the coming weeks.

But what is important is that following the attack, the Luna Foundation Guard, a Singapore-based entity designed to protect the 1:1 peg, rushed in and stated that it was actively trying to defend UST’s position.

But a crisis of confidence quickly emerged and the UST “bank run” continued.

In the first days following the attack, the Terra team was sending a message that it was working on a solution.

Some of the updates were given by Terra founder Do Kwon directly.

However, things quickly took a turn for the worst.

Rumors started coming out that many of the large trading firms (some of whom were very supportive of Terra in the past) would not bail out Terra.

As redemptions were taking place on UST, more and more Luna had to be issued (remember that each UST redemption equals a $1 amount in Luna) and this led to a death spiral, as the more users were redeeming UST, the more Luna was being issued, which lead to a vicious cycle.

Eventually, this would lead to UST falling to under $0.10 from its intended $1 mark, and the price of Luna to de facto 0.

Now, was this predictable?

The short answer is yes, as many in the crypto community have long been skeptical of Terra.

Many members of the crypto community, from Swan Bitcoin’s CEO Cory Klippsten and University of Calgary’s Dr. Ryan Clements to Galois Capital’s Kevin Zhou were very vocal about this issue, warning about the risk of Terra’s collapse.

However, the 20% returns on UST on the Anchor protocol and other venues were too attractive for many, not only enticing retail investors but many crypto hedge funds, as well.

There was also criticism of the very cocky attitude of Do Kwon.

For example, he frequently bragged about how Terra was going to destroy other stablecoins and was often very dismissive of anyone who dared to criticise him.

He even named his baby daughter Luna.

However, the damage of the collapse of UST also expanded to the entire Terra blockchain. Validations were halted and the entire Terra ecosystem basically came to an end.

Now, what does this mean for the stablecoin ecosystem moving forward?

First, there will be practical consequences, due to both retail and institutional investor losses.

Many retail investors, especially investors in South Korea where Do Kwon was based, have lost a lot of their savings.

Media reports have already circulated of people committing suicide and even of individuals going to Kwon’s home.

Many investors had bragged on TikTok and other social media channels about how they were borrowing cash and then putting it into the Terra ecosystem.

We should also expect many lawsuits, especially due to the fact that there was a company behind the project called Terraform Labs with a CEO that was as vocal and public as Do Kwon.

We should expect everything from class-action lawsuits to more niche actions to be launched over the coming weeks.

These will drag on for years, but they will still give some hope to the retail investors who have lost significant amounts of money that they will be able to put their hands on some of the assets that Do Kwon and others may have potentially hidden away.

Many crypto hedge funds have lost a lot of money, as well.

Let’s not forget that almost $18 billion in value has been destroyed and many entities will be impacted. Many crypto hedge funds had assets either on Anchor or were long Luna.

We should expect to see many crypto hedge funds later this month or at the end of next month when the typical quarterly redemption cycle kicks in to implement fund gates or set up side pockets; some may simply shut down.

But many developers and start-ups will have also seen their projects destroyed through no fault of their own, as they were building on the Terra ecosystem.

This is somewhat similar to building a game for the iOS ecosystem until Apple suddenly ceases to operate. Yes, some of the projects will be able to build on other chains (many of them do), but this will have a negative impact.

Second, this give will give the stablecoin ecosystem a bad name.

But this is unjustified, as many of the asset backed or regulated stablecoins (e.g. USDC, TUSD, USDP) are very transparent. USDC (Circle) and USDP (Paxos) are both issued by regulated entities, for example, and have made commendable efforts to show the proof of their reserves.

Even USDT (Tether), which came under scrutiny over its reserves in recent years but has made strides in improving its transparency. Tether now looks like a good student, relatively speaking, when compared to UST.

But the Terra incident will have many people taint all stablecoins with the same brush regardless of the fact that algorithmic stablecoins are in a category of their own.

This will give ammunition to regulators, who will probably seize the opportunity to scrutinise the ecosystem.

We have already seen this take place, from Janet Yellen asking that the space be regulated to the Financial Stability Board seeking to be the leading regulator of this space.

And there will be political pressure as well, as many retail investors have lost money in this collapse.

In the same way that we saw the effects of the Lehman Brothers crash for over a decade in traditional finance, the same will be true in crypto markets.

Whilst this will not stop the development of the digital assets space, it will slow it down in certain verticals. For example, this may give some traditional financial institutions cold feet to enter the space. In certain countries where UST had an outsized impact, South Korea being the main example, regulators may take an even more aggressive stance.

The third consequence will be the reaction of central banks.

According to a recent report from the IMF, the biggest threat to central banks, especially those in emerging markets, are stablecoins (which we recently covered in this newsletter).

This incident will now give central banks the ammunition they need to try to take action against stablecoins.

As I have explained in this newsletter in the past, U.S. dollar stablecoins are a direct threat to local currencies of non-G7 countries, especially when there is inflation or instability. This is something we are already seeing in places like Turkey and Argentina for example.

Central banks can ask local banks not to support stablecoins, for example, or can ban payment companies from using stablecoins for cross-border payments. It was reported that the European Union is potentially looking at baning stablecoins, for example.

Whilst it is unlikely we will see this in the U.S., these actions are likely in smaller economies. Central banks will know that this opportunity may not present itself again soon in such a way.

But conversely, there are some positive consequences, as well.

The collapse of Terra/Luna will hopefully force investors to be cautious and spend some time looking at the token economics of a project before investing in it.

This collapse also reflected poorly on the supposed tier 1 venture capital firms that invested in the project. Firms like Galaxy Digital and Pantera Capital were notable investors in Terra.

Many VCs have simply adopted a spray and pray approach over the past two years in crypto, and we should hope (although I doubt it will have an impact) that some allocators will now question their VCs on what type of due diligence they perform on their investee companies in exchange of their management and performance fees. 2/20 is an expensive proposition for pure exposure to the asset class if the VCs are not doing their job.

Second, some heroes will be made from this crisis.

Kevin Zhou of Galois Capital, for example, will be known as the Michael Burry of Scion Asset Management (as depicted in The Big Short) for his analysis of this scandal. He wrote a very interesting post-mortem tweet following the event calling it “The Sacking of Crypto Carthage”.

We should also expect a movie or two (in addition to a number of documentaries) about this blowup; the cocky attitude of Do Kwon will undoubtedly make for great cinema.

The crypto industry has learned in the past from other meltdowns.

Counterparty risk considerations improved after each scandal, from the Mt. Gox collapse to Quadriga. And cybersecurity has been strengthened after each hack, from Bitfinex to the Ronin hack.

Now, let’s hope that the industry learns from the mistakes of this scandal. Having been in the crypto industry since 2014 and seen this movie before, I know the industry will push forward. Unfortunately, many paid the price for this hard-earned lesson.

Whilst this scandal unfolded in less than a week, it will be with us for years to come.

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See you all next week!!

Henri Arslanian

*Please note that this newsletter reflects Henri’s personal views and not those of any organisation he is involved with. This newsletter is for educational purposes only and none of its content should be construed as investment or financial advice of any kind.

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By Henri Arslanian

Future of Finance and Money - PwC Global Crypto Leader, Best Selling Author, Keynote Speaker, University Professor, Host of Crypto Capsule™ - Views are my own

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