The recent FTX crash, which has seen over $150 billion wiped off the crypto market in a few days, brings back memories of another prominent crash, one which had far more serious consequences. Many retail investors lost their life savings. Also, a few businesses had to file for bankruptcy while others were liquidated.
This piece seeks to examine what happened back in May leading up to the Terra crash and the impact it had on the crypto market afterward. But first, let us briefly explore what the Terra network was all about to put things into context.
Understanding the Terra Network
The Terra network was launched at the start of 2018 by Do Kwon and Daniel Shin. The end goal was to create a decentralized e-commerce payment system that would rival established centralized counterparts such as PayPal and Visa.
To make this goal possible, the network had two tokens: Terra USD, better known as UST, and Luna. The former was a stablecoin whose price was supposed to be $1, and the latter was a utility token on which the price of UST was pegged.
Unlike centralized stablecoins like USDT or USDC, whose value is directly pegged to the US dollar, or decentralized ones like DAI backed by collateral, UST was backed by algorithms, game theory, and the notion that it would maintain its peg in the long run.
That said, the price of Luna was set by the market, and 1 UST was supposed to be equal to $1 worth of Luna. Even though the amount of Luna received during swaps would change depending on its price, UST holders were guaranteed to receive their dollar value.
To maintain the peg, there were arbitrage opportunities that incentivized traders.
Understanding the UST — Luna Peg
The Terra system was designed in such a way that the value of 1 UST would be exchanged for a given quantity of Luna that had a market value of $1. When the exchange happened, the other was taken out of circulation to maintain the system. This was handled by smart contracts.
Therefore, in a scenario where the price of 1 UST was above $1, traders would be incentivized to trade $1 of Luna for the stablecoin for an instant profit. As a result, more UST would be minted and added to the system, which would drive its price down.
On the other hand, if the price of 1 UST was below $1, traders would be incentivized to trade it for $1 of Luna, thus profiting from the difference. Consequently, more UST would leave the system, thus driving its price up.
Why did Terra crash?
Before touching on what caused the Terra network to crash, it’s important to highlight other factors that were at play and contributed to the demise of the network. As an ecosystem, Terra had the Anchor Protocol, a decentralized money market where UST holders would stake their tokens and get 20 percent in annual yield. The protocol would take the deposits and loan them out at interest, which was used to pay the stakers.
This made the protocol quite popular among UST holders. At one point, the platform held over 72 percent of UST in circulation, and it was the main driver of demand for the stablecoin.
However, there were skeptics who wondered where the money to pay the high yields came from and likened the process to a Ponzi scheme.
Given the tumultuous history of algorithmic stablecoins, Do Kwon and his team launched the Luna Foundation Guard (LFD) at the start of the year. The organization had two duties: building reserves to support the UST peg in volatile market conditions and supporting the growth of the Terra ecosystem through grants.
By the time Terra crashed in May, LFD had amassed around 80,000 BTC in its wallets to protect the UST peg. Almost all these bitcoins would be lost as the foundation tried to revive UST.
Terra crash: Five days in May
Trouble began on May 7, 2022, when a bot that watches the curve protocol noticed huge amounts of UST being exchanged for USDC. To be precise, 85 million UST was swapped for 84.5 million USDC. On the same day, in what many believe was a reaction to the capital flight, $2 billion worth of UST was unstaked from Anchor Protocol.
The next day, the value of 1 UST would drop below $0.985. LPG would react to the situation by committing to loan market makers $750 million of its BTC reserves to defend the peg. Also, the organization committed another $750 million in UST to buy back the bitcoins after the volatility had cooled down.
On May 9, 2022, the UST would lose its dollar peg again for the second time, dropping as low as 35 cents. All this while, more Luna was being minted to stabilize the UST as more people sold the stablecoin in panic. This led to the overminting of Luna, increasing its circulating supply.
By May 12, Luna, which had traded at an all-time high of $116 a month earlier, had lost all its value, trading at less than 10 cents. The token was delisted on several exchanges, and the Terra blockchain was halted.
What happened?
Contrary to circulating rumors at the time, Terra’s crash wasn’t caused by a single malicious actor that sought to destabilize UST. Researchers at Nansen, an on-chain analytics firm, found out that several large holders of UST had opted to sell the stablecoin as they found it too risky, and this caused a domino effect, putting more selling pressure on UST.
Terra wasn’t the first algorithmic stablecoin to crash. All previous attempts to create one failed. For this reason, many were skeptical of Terra from the start. One such individual was Linda Xie, a DeFi researcher at Scalar Capital, who predicted Terra’s downfall four months after it was launched in 2018. She would be vindicated 4 years later.
Interestingly, on May 11, 2022, Do Kwon was exposed as one of the pseudonymous creators of Basis Cash, an algo-backed stablecoin that had failed in the past.
The impact the Terra crash had on the crypto market
Following the meltdown of Terra, the crypto market, which was already facing tough times, went into panic mode. Over $300 billion would be shed from the market cap in a few days, with $60 billion belonging to the Terra ecosystem.
The likes of Three Arrows Capital (3AC), Celsius Network, and Voyager had to file for bankruptcy. Institutional investors such as Hashed would lose over $3.5 billion. And many retail investors saw their life savings go up in smoke. Do Kwon would go into hiding, and despite many arrest warrants by South Korean authorities, he is still at large. He retains his innocence and claims he isn’t hiding.
After Terra crashed, the network was forked without UST. The current chain is dubbed Terra Classic.
This article was originally published on DataDrivenInvestor and was submitted to TechNode Global as an editorial contribution. TechNode Global INSIDER publishes contributions relevant to entrepreneurship and innovation. You may submit your own original or published contributions subject to editorial discretion.
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