The $1 Trillion Kaboom: Lessons Learned From Terra Luna, the Biggest Crash in Crypto History
Terra, one of the most promising, widely-used, and fiercely-loved crypto projects, has been all but destroyed in just a few days. There are indications that a weakness in Terra’s tokenomics was leveraged to attack Bitcoin for the sole purpose of winning a billion-dollar wager against the mother of all crypto. Unchained. The Blockpit Magazine explores what happened in May 2022 and what can be learned from it.
“The fact that UST broke its peg to the dollar, and that LUNA is down from an all-time high of $119 to its current price of $0.09 is a big, big deal. It’s broken an already shaky market. And if you’re at all interested in crypto, you should understand what happened.”John Wu
“Kwon is a visionary genius, but his hubris killed Terra.”Recovering TradFi Chad in his newsletter about Terra Founder Do Kwon
The inner workings of stablecoins
To appreciate how a trillion Dollar meltdown happened, one has to dissect the mechanisms of stablecoins such as Terra’s UST. If you know your USDT from your UST, you can skip to the next section and jump into the financial bloodbath.
Looking at the world in a simplified black-and-white, bipolar way, money allows two actions: it can be spent, and it can be earned. To put it in slightly more professional terms, money is used for payments or for investments. Both are needed in a modern capitalist economy which becomes evident by looking at how value changes with each use.
Ain’t no money stable
Buying groceries, paying rent, or salaries requires money that is relatively stable versus the assets bought. Not only does it irritate consumers if a bottle of Fizzy Bubbele costs $1 today, 37 cents tomorrow, and $2.59 the day after – it also makes planning difficult. Very bad for an economy.
Investment assets, however, live by their fluctuating valuations, otherwise, nobody would buy them. Crypto assets are attractive because they have high volatility, which promises high returns (paired with proportionally high risk).
Money is introduced by an issuer – a national bank in fiat or a project in crypto – and then given to the market. The sum of all market participants decides the value of the money. If all the landlords in your country think that rent should increase by 5%, suddenly your money is worth 5% less.
The issuer has only limited control. The central bank can’t decide that a unit of the currency should always buy the same goods, the markets do. Inside the country, the issuer can steer the value of money by either printing more when more is needed (which makes money less valuable) or burning money for the opposite effect. Since the market always moves faster than the central bank, the value of money always fluctuates. If the economy is healthy and the central bank does good steering, consumers barely recognize the fluctuation.
The invention of the crypto stablecoin
The first few years of the crypto economy only offered assets that functioned as investments. Bitcoin and Ether are the most famous. They were good for speculating but bad for making payments, except if a consumer likes to play the lottery when buying a cup of coffee.
Mimicking the fiat economy, the first major stablecoins were introduced (among them the currently biggest, Tether) in 2016.
These first stablecoins were pegged to a fiat currency. One Tether (or USDT) is worth one US Dollar. So is the stablecoin of Terra (UST) or the one from Binance (BUSD). People use stablecoins to make payments or to park money in between investments. Stablecoins are crucial for most DeFi applications.
However, stablecoins can’t be completely stable since the market makes the price. Just as with fiat currency, the emitter has to balance demand and supply to keep it somewhat stable. It would be more precise to call them low-volatility coins, but that doesn’t quite have a ring to it.
The founder of TerraLabs, Do Kwon once tweeted the above screenshot. It shows the ten biggest stablecoins that all oscillate between $0.94 and $0.99 with Terra’s own UST hitting a clean $1.00 which is a rare event (but only has symbolic value). Every stablecoin issuer must actively steer the coin to be as close to $1, as often as possible.
The big Kahuna of stablecoins, Tether, does that with a fiat promise. The issuer says that when a buyer buys one USDT with fiat or crypto, they put one fiat dollar on a regular bank account (That is a story-driven simplification, Tether uses several assets as reserves). That stablecoin is pegged to fiat. This should guarantee that a USDT owner can always exchange the token back for a fiat dollar. The issuer maintains low volatility by minting new USDT when they receive money and burning Tether when they buy it back.
That is swell and no other stablecoin is ever needed? Not quite, as Tether comes with two caveats. If the issuer mints 100 billion USDT, they have to put the same fiat amount on a bank account. This is money that doesn’t work or only for very low yields. Some say it defeats the purpose of a purely virtual cryptocurrency if you peg it to fiat. The second problem is trust.
Tether’s issuers, controlled by the crypto exchange Bitfinex, don’t allow public examination of their bank accounts. Do they have the $76 billion (May 2022) in reserve? Or at least a fraction? Or maybe nothing at all? The public doesn’t know and allegations of fraud riddle the internet.
Meet TerraUSD – a stablecoin with no Dollar
Terra calls itself a DeFi ecosystem that works with two coins. One is TerraUSD (UST) – the stablecoin. The second is Terra (LUNA) which is called a governance and utility token. Ownership of this volatile asset gives control over the ecosystem. Its volatility also makes it a good investment token, representing the value the crypto community gives the ecosystem.
If an asset is pegged to another asset (like Tether to USD), it needs to have a similar value stored as a reserve. Terra didn’t want to hold expensive fiat Dollars in reserve. They followed the example set by practically every central bank in the world which is not holding gold in reserve for their own currency. Terra created an algorithmic stablecoin. The algorithm constantly checks the demand of the stablecoin. If the demand rises, more UST is created, if it falls, UST will be burned. This was supposed to maintain an equilibrium set at 1 UST = 1 fiat USD.
The process described that whenever 1 new UST was created, one dollar worth of LUNA got burned and vice versa. The reserve for UST is LUNA. If the UST price was higher than $1 arbitrage users would sell off until the price dropped. If UST price was lower than $1, arbitrage users would buy them at a slight discount and swap them for LUNA. This constant selling and buying maintained the price at around the one dollar mark.
This is quite a smart system as it allows to have a low-volatile currency without the expensive fiat money reserve. The tech-wizards at TerraLabs even went a step further: Growing demand for the stablecoin meant burning the governance token LUNA. Having less LUNA made the remaining tokens scarcer and thus more valuable.
This mechanism creates a positive feedback loop as long as the economy is growing: higher demand for stablecoins makes the reserve more valuable. A more valuable reserve encourages people to accumulate or spend more which creates more demand in stablecoins.
This spiral worked like magic. In March 2021, one billion UST were minted, in December there were already ten billion. The apex was reached in early May of 2022 with 18 billion UST. The price of LUNA moved in a similar direction: $8 in March 2021 and $100 in December. However, the downturn in the crypto market let LUNAs value drop to around $80 in May 2022. Right around that time, LUNA had a total market cap of $30 billion.
This growth could go on forever and there would only be happy campers. However, no bull market lasts forever. “It’s the downside that’s important to protect,” says John Wu in his post. “The way to do that is giving people a reason to hold $UST, or some kind of utility. Stablecoins Require Utility™ to maintain demand and defend their peg.”
With 90% of all UST locked in the App Anchor, Terra had that utility. Anchor is a savings scheme that pays nearly 20% annual interest. That yield is 20% more than humans currently get on any European fiat savings account. Who wouldn’t make such a saving with a stablecoin that has no volatility? Nobody. What could go wrong?
Turns out, everything. The meltdown
It is May 9, 2pm CET. Suddenly, the price for the until-then stablecoin UST drops. For the next five hours, the drop from $0.94 crosses a psychological mark to $0.93 but millions of traders are still not concerned. Then the price starts to slide.
Sometimes, charts can tell a story. Somewhere around midnight, the price of UST drops to 88 cents within a minute or two. Someone, presumably Terra itself, fights back by selling LUNA and Bitcoin and buying UST. But that doesn’t hold the slide. Right around 1:40am the stablecoin drops to an unprecedented 66 cents – a death sentence for an asset that lives only due to its stability.
The black bars at the bottom of the charts show the trading volume. It’s gradually rising. In the 24 hours before 7pm on the 9th, users have traded $1.2b worth of UST. Another billion was sold until 2 in the next morning and a further billion was used to stabilize the price in the wee hours of the day. Do Kwon declares that Terra will spend $0.75b in LUNA and $0.75 in Bitcoin to stabilize UST.
Terras’ attempt to stabilize the now-very-unstable coin pays off. During the day the price reaches 88 cents. Bad, but that could work. Terra fans and investors rejoice. There was an attack by some nebulous billionaires they say on Twitter and reddit, but the system prevailed.
“Deploying more capital – steady lads”
Do Kwon, Founder of Terra on Twitter, May 9, 8:36pm CET
However, that comeback turns out to be a short reprieve. The trading volume increases with every hour, reaching five billion dollars (for a 24h period) on May 10. Now, two parties fight with all their might – the nefarious attackers to kill UST, Terra to save it.
How does the defender respond? Terra sells off their own LUNA and Bitcoin holdings to buy back UST. Selling LUNA lowers its price and puts the whole project under pressure. Selling Bitcoin puts a further dent in an already downwards overall market.
“Close to announcing a recovery plan for $UST. Hang tight.”
Do Kwon, Founder of Terra on Twitter, May 10, 5:32pm CET
“In other words, UST is stabilized by: […] The gigantic gravity well created by the size of Do Kwon’s nuts.”
Jon Wu, Ava Labs
Terra founder Do Kwon comes up with a rescue plan. According to Investor “Route 2FI”, the plan didn’t convince any big market makers to come to Terra’s rescue. “There is basically no plan”, writes Route 2FI.
In the morning of the 11th, the fight is lost when retail investors start offloading, trying to cut their losses. Fear grips the market participants, LUNA drops to cents and below. Traders move out of other cryptocurrencies to Bitcoin and from Bitcoin back to fiat. A week later the smoke has cleared, the crypto market has just lost one trillion Dollars. What a meltdown.
You didn’t see the trick that was pulled off before your own eyes? Neither did most other cryptonians. Come closer, look hard, let’s rewind and play it back in slow motion: A mini-meltdown happened to Terra already in January 2022. The implosion of a service building on Terra forced TerraLabs into an expensive and risky stabilization buy-back. A close call and the fortunes were on the side of Terra. However, that event must have spooked the Terrarians. They sold off $1 billion worth of LUNA in a private sale and bought Bitcoin to diversify their risk.
It could be speculated that TerraLabs knew that there was a weakness in their tokenomics. They obviously didn’t know what fate awaited them. A tech observer named 4484 posted on May 10 what he thought had happened:
The nebulous attacker accumulated $1b worth of UST over several weeks. They further borrowed $3b in Bitcoin – from Gemini as investor Route 2FI claims and Gemini denies – and at some point held a massive amount of crypto money. They then told the world how flawed Terra is (one could argue that they told what is). Finally, at a precise moment when Terra had a planned software change with low liquidity (and thus lower resilience), they threw the UST on the market driving the value far below the $1 peg. The built-in mechanism to stabilize the coin was overwhelmed.
Terra sacrificed much of their LUNA value to stabilize in the coming hours. Then the attackers sold all of the Bitcoin, lowering that price which devalued Terra’s BTC reserves. The attackers speculated that mass panic would ensue, driving the market to melting point. They made a correct prediction. Kaboom! And the rest is history.
The Why and the Who
The “why” has a logical answer as a possibility, as technologist 4484 writes. When traders buy assets, they make a bet that the prices will rise. They can also make bets on falling prices if they find a second party willing to bet against. Despite the slowing market, the attackers found enough traders betting that Bitcoin would not drop as there were no events in the market pointing to a crash. Except that the attackers had actively prepared a crash, leveraging a weakness in one of the biggest coins (Terra), foreseeing the massive sale of Bitcoin by TerraLabs to stabilize UST and the flight instinct of the herd of traders.
If that is what actually happened then Terra was nothing more than a patsy in a scheme to pocket a few billion dollars in the bet against Bitcoin.
The question of the “who” is far more difficult to answer. There are allegations that hedge funds Blackrock and Citadel were responsible for this willful act of destruction. Blackrock denied having anything to do with it. Spectators pointed out that the sell orders linked to the meltdown could be traced back to them. At the time of writing, the truth is still obscured in the fog of (trading-) war.
“Another more plausible explanation revolves around the earlier identified potential Achilles heel of the system: the Anchor lending protocol, which offers extremely high 20% yield (APY) on deposits,” writes Ruben Merre, CEO of @ngrave. “It is argued that users were flocking in rather for the unsustainable (?) yields than the actual stability of the coin. This would make Anchor a ticking time bomb until the yields and money would dry up and with it UST’s willing holders.”
The price of learning
“I lost over 450k usd, I cannot pay the bank. I will lose my home soon. I’ll become homeless. suicide is the only way out for me.”
Anonymous on Reddit
The crash of arguably one of the most promising DeFi projects is painful for those who invested in the project and increases fears of a crypto bear market. We sat down with Stefan Schürz, Head of Research at Blockpit to draw up five lessons that we can learn from this.
- Don’t invest just because of FOMO
There was a lot of hype surrounding Terra. Indeed, the project seemed practically invincible and there was even talk of Terra credit cards. Don’t invest because it seems like the next big thing, or because lots of people are talking about it. Invest in projects you believe in and take the time to “DYOR”, or Do Your Own Research. We know that it is extremely hard to do so and it doesn’t prevent all failures. But it can prevent enough.
- Pay attention to macroeconomic trends
What’s going on in the world, beyond the crypto rabbit hole, reveals a lot about what to expect in the market. Between the pandemic, the situation in Ukraine, supply chain shortages and increased energy prices, there are many signs of inflation and possibly an upcoming recession. Betting against a recession is an even riskier business than investing during a bull market.
- Don’t blindly trust algorithms
As the Terra project shows, algorithms can mess up. If you still want to invest in algorithmic coins, consider how extensively the technology has been tested and how scaleable it is.
- The risk is in the number
Nearly everybody went for the 19.5% interest rate when depositing UST. High yield always comes with high risk. While there is no direct correlation to the number, one can expect a 19.5% risk of losing your investment. Are you really willing to take that risk?
- Diversify your portfolio
The worst affected are the ones who have the majority of their crypto investments in Terra. Spread the risk, so that if the worst happens, you won’t lose everything. That doesn’t mean you can’t invest in risky projects, but weigh up the risks before investing, and ensure your portfolio doesn’t consist entirely of risk assets. Given that crypto is young and volatile, everything in this space is risky.
Jacob Canfield, trader and maybe the first to retweet the anonymous reddit allegation of Citadel’s and Blackrock’s involvement adds one more lesson via Twitter:
“It’s good to listen to FUD. Analyze it and investigate it. Especially when it’s about investments you hold. Follow accounts that contradict your beliefs to challenge you and make you uncomfortable. This will give you all sides to make informed decisions.”
Bitter irony and one final advice
“95% [of coins] are going to die, but there’s also entertainment in watching [them] die too.”
Do Kwon, Founder of Terra in an interview on May 3.
Whoever executed the attack on Terra might have gained $815 million on its bet, as Twitter analyst Onchain Wizard speculates.
The Twitterverse is now bustling with everybody and their dog having known that algorithmic stablecoins can’t work, high yield is a Ponzi and that Terra is mega vulnerable. Unfortunately, the Cassandras of crypto just retweeted their analyses from months ago. It turns out, the writing was on the wall – ehm on the feed. We were all just blinded by 19.5% annual yield.
Investing in crypto is not for the faint of heart. Stay safe and better err on the side of caution.