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The collapse of Terra Luna and UST

Terra Luna and UST were among the ten most popular cryptocurrencies in 2022. Yet, the whole ecosystem collapsed in just a couple of days. How was that possible? This article goes through the details and the aftermath of Terra’s collapse. Please note that the future of Terra is not yet fully known at the time of writing this article. We will update the information as the situation evolves.

Anchor protocol was behind Terra’s popularity

Let’s first go through the background of Terra’s collapse. It’s important to understand what made both Luna and UST so popular in the first place. To learn more about Terra’s technology and background, read our Terra guide. This article was written before Terra’s collapse.

Terra was one of the most popular smart contract platforms in the market. It competed in the same category with Ethereum, Solana, and Cardano. Luna was Terra’s native token. It was used for transaction fees and staking.

Terra stood out from other smart contract platforms because of the UST stablecoin.

  • UST was an algorithmic stablecoin unlike other major stablecoins (USDC, USDT, etc.)
  • UST was a native stablecoin in Terra’s blockchain

The price of UST was pegged to one dollar through arbitrage. If the price fluctuated to $0.99 or $1.01, market makers had an incentive to bring it back to par.

Each UST was minted by burning the equivalent dollar amount of Luna. Hence, the demand for UST burned the supply of Luna, thus raising its price. Similarly, one UST could be exchanged for one dollar worth of Luna tokens.

Why did the popularity of UST skyrocket in 2022? The reason was a lending platform called Anchor protocol. It was a DeFi application running on Terra’s blockchain. Anchor had $17 billion worth of liquidity before the collapse making it the second-largest DeFi app in the market.

anchorapp

The fundamental idea of Anchor is no different from other lending platforms: depositors receive an interest rate on their money that is slightly lower than the interest paid by borrowers. The service earns the spread. However, Anchor offered an exceptional 19.5% APY on UST deposits. Interest rates on stablecoins usually hover in the 5-10% range.

Anchor was able to offer this rate because Terra paid the difference. This was a marketing operation for increasing UST’s popularity. The tactic worked very well. UST was by far the fastest-growing stablecoin in the spring of 2022. Its market value reached almost $19 billion.

Terra’s native token Luna rose to a market value of $40 billion in the wake of UST. At its peak, it was the sixth largest cryptocurrency and the third largest smart contract platform after Ethereum and BNB Chain.

Terra’s controversial leader Do Kwon

Terra’s success brought also Do Kwon to the limelight. He founded Terra in January 2018 together with Daniel Shin. Kwon’s partner stepped aside two years later to start a payment app called Chai, one of the biggest users of Terra’s KRT stablecoin.

Do Kwon did not rise to prominence just because of Terra. He became famous for his aggressive and arrogant Twitter behavior. Do Kwon was particularly confrontational with Terra critics. He wasn’t exactly respectful towards other crypto projects either.

For example, Kwon tweeted in March 2022 “By my hand $DAI will die”, when UST overtook DAI in market cap. Kwon also chuckled in an interview about how the collapse of other projects is entertaining to watch. In March 2022, Kwon placed a $10 million public bet on Luna’s price performance.

There is a long list of similar examples.

The defiant presence of the Terra leader continued until the end. This is what the man tweeted on 8 May, when the first suspicions of UST instability began to appear.

In case the tweet is deleted: “I’m up – amusing morning. Anon, you could listen to CT influensooors about UST depegging for the 69th time. Or you could remember they’re all now poor, and go for a run instead. Wyd.” Kwon’s tweet was written just moments before the house of cards collapsed.

Was Kwon’s arrogance one of the biggest reasons for Terra’s downfall? Did he manage to anger too many “whales” with his comments? We will never know for certain.

And that’s not all. Coindesk also reported a few days after Terra’s collapse that Do Kwon was one of the anonymous founders of Basis Cash. It was a failed algorithmic stablecoin that lost its dollar peg in early 2021. This information would certainly have been of interest to many.

The collapse of Terra Luna and UST

The countdown of UST started on Saturday 7th of May 2022. It all began at Curve, which is the most popular DeFi app on the market. Curve is designed specifically for trading stablecoins. It contains different pools of stablecoins. UST was a prominent participant in these.

You can also rewind through the events in the Coin Bureau video below. It should start automatically at 22:52.

The causes of the collapse are not entirely agreed upon, and there are many technical details to the events. We will try to simplify the story so it doesn’t get too complicated.

It seems that there was an attack performed against Terra by one or more entities. The UST stablecoin was attacked right after Terra removed a huge amount of liquidity from one of Curve’s pools. In the immediate aftermath, hostile parties dumped a huge amount of UST stablecoins into the market, causing its dollar peg to fall to just below one dollar.

At first glance, it might seem that a stablecoin falling to $0.98 is not a disaster. However, it is all about confidence. In the case of the UST, it was accentuated by the lack of any real reserves. The UST-Luna-UST mechanism started to break down when all buyers disappeared from the market.

Investors panicked and started selling more and more UST, which only made the issue worse. The result was the kind of death spiral that experts had warned about. As the panic escalated, billions of dollars of liquidity were also withdrawn from the Anchor protocol.

Bitcoin reserve did not help Terra

The interesting thing is that Terra had actually prepared for such an attack for months. Terra was one of the largest Bitcoin holders at the time of the crash. The company had managed to acquire more than 80,000 bitcoins worth around three billion dollars.

Terra’s purchases were even praised by Bitcoin supporters.

According to one theory, Do Kwon’s goal was to make Terra such a large Bitcoin whale that the market would have an incentive to keep it together. Who would want to attack UST if it meant dumping $10 billion (Terra’s target for Bitcoin reserves) worth of bitcoins into the market?

In the end, Bitcoin did not help Terra at all. The company tried to save the situation by selling almost all of its bitcoins, which contributed to the Bitcoin price dropping to almost $25,000.

There are rumors that the entities behind the attack had also borrowed hundreds of millions (up to 1+ billion) dollars worth of bitcoin. They were dumped on the market at the same time as the UST. This created further panic and contributed to the collapse of Luna.

The timing of the attack was perfect. The market was already in a very fragile state, so panic spread like wildfire. In a normal situation, or in a bull market, there would have been no problem. There would have been large-scale buyers on the other side. Now everyone just wanted to get rid of their UST and Luna tokens as quickly as possible.

For the investor, the situation was simple: there is no point in holding a single dollar in a stablecoin that has even a small risk of collapse. Everyone played it safe and dumped UST into the market. The attacker provided fuel to the fire and the market took care of the rest.

The UST collapsed far below the one-dollar peg in a couple of days. At the same time, the Luna token plunged to zero. Below are Luna’s price graphics from the time of the event.

terra-luna

The collapse of Luna was a direct consequence of the UST’s operating mechanism. Ironically, the system worked exactly as designed.

Each UST could be exchanged for one dollar worth of Luna tokens. Now it was possible to buy a UST token at a discount and mint $1 worth of Luna tokens. This profit could be obtained by selling Luna for euros or dollars. A spiral was created, which completely destroyed the value of Luna.

There are other details too, not all of which we will go into here. Those interested in the collapse in more detail will find a lot more information on YouTube

Investors suffer huge losses

Terra Luna’s market cap was just over $26 billion on the 6th of May 2022. The UST had a market cap of almost $19 billion at the same time. This means that almost $45 billion disappeared from the market in just a few days.

By comparison, the entire crypto market was worth around $280 billion just two years ago.

The collapse of Luna and UST is something truly exceptional. Many long-time investors recalled the collapse of Bitconnect in January 2018. Here’s how they tweeted about it four years ago.

Bitconnect’s market cap was only a few billion dollars, but it was a large-scale cryptocurrency in 2017-2018. Though Bitconnect’s USD losses were small compared to Terra, both cases involved a large number of investors.

Terra’s collapse was several orders of magnitude worse because of UST. It was (at least in theory) a stablecoin, where investors parked their money to protect themselves from volatility. This need had become even more acute in 2022 due to the bear market.  The 20% interest rate of the Anchor Protocol also served as a strong incentive.

The collapse of Terra also affected industry professionals. Terra had raised hundreds of millions of dollars from the biggest VC firms. Many hedge funds had invested their UST coins in the Anchor protocol.

Seasoned investor Mike Novogratz was thrust into the spotlight after the incident.

Novogratz is the founder of Galaxy Digital, a publicly traded company. His company suffered hundreds of millions in losses and Novogratz had also taken a Luna tattoo in January 2022. Ouch!

According to Coindesk, a Korean company Hashed lost over three billion dollars. More than 200,000 small investors lost their savings in South Korea alone. Terra was a popular investment in South Korea, as it is the home country of the founder Do Kwon.

The crypto exchange Binance was also one of the early investors. It possessed 15 million Luna tokens, which went from a value of over $1.6 billion to zero. Let’s not forget the Luna Foundation Guard. Terra’s supporting company lost over $3 billion in reserves trying to save the UST from collapse.

Only time will tell what the final damages will look like. One thing is certain; the collapse of Terra was costly also for the industry pros. This was not just some retail meme coin.

Events after the collapse

Social media was full of speculation immediately after the crash. According to a popular theory, financial giants Blackrock and Citadel borrowed 100,000 bitcoins from the Gemini exchange and dumped them on the market. All parties have denied this.

It was also interesting that US Treasury Secretary Janet Yellen was able to describe the collapse of Terra and its effects only a day later in a press conference.

As mentioned earlier, Do Kwon was certainly not short of enemies. There are also theories that Terra used the previously mentioned Bitcoin reserve to bailout certain whales. We might never get all the answers. There’s room for a lot of speculation and conspiracy theories.

Terra’s collapse also led to a momentary de-pegging of Tether. USDT lost its peg due to a panic run toward USDC. At worst, it was trading at a discount of more than 15% against USDC. This panic died out after a couple of hours. Tether also released a report on its reserves last week to reassure investors.

The collapse of Luna also caused a risk to the security of the Terra blockchain. It would have been easy for a hostile party to acquire a large stake by buying tokens at a knock-down price. This led to the blockchain being shut down on several occasions.

Terra 2.0

Now we have studied the background and the aftermath of the collapse. It’s time to look forward. Is it possible for Terra to rebuild the ecosystem after such a disaster? This is what investors, software developers, and the Lunatics (Terra community members) are all pondering right now. Note that this chapter was written on 5/30/22.

Terra founder Do Kwon didn’t disappear after the collapse like many might have expected. He started to organize a rescue package for the ecosystem immediately. This led to Proposition 1623, which was handed to the community to vote. It was first announced as a hard fork, but this was not the case. Prop 1623 was all about creating a brand new blockchain.

The Twitter thread below explains the details.

Since a new blockchain was to be created, it needed a new token as well. The old Terra blockchain was renamed Terra Classic and the old Luna to Luna Classic. The UST stablecoin was abandoned as a failed experiment. There are no more algorithmic stablecoins in the “Terra 2.0” ecosystem.

The recovery package was confirmed 25th of May with 65% of the votes. This is not a big surprise, since many investors hope to regain some of their losses through the new Luna token.

Terra 2.0 was officially launched on Saturday 28th.

A new Luna token was launched the same time. It inherited the LUNA ticker from the old token, which in return got a ticker LUNC. It was somewhat surprising to see that Terra 2.0 was supported by the biggest exchanges. Binance, KuCoin, FTX, and Kraken were among the exchanges that listed the new Luna token quickly.

The new Luna will be airdropped to investors who owned the old Luna and UST. Only a small number of the supply was airdropped when the blockchain was launched. You are entitled to the airdrop if you had Luna and UST before or after the collapse. It depends on the exchange or the wallet being used how the tokens can be claimed.

Terra 2.0 has been out for a few days now. The new Luna token was available for trading at $17.8 according to Coinmarketcap. The price crashed to $6 in a matter of hours. This is the price level the Luna token has stabilized at.

It’s easy to see why the community wants to rescue the Terra brand. The biggest question is: what competitive advantages Terra 2.0 has? UST was the reason why Terra was so popular in the first place. It made the platform stand out from the crowd. Now Terra is just like dozens of other smart contract platforms. The name Terra will also remind investors of the May 2022 disaster forever.

We recommend exercising extreme caution when it comes to investing in Luna.

Lessons for investors

The collapse of Terra will go down in history as one of the biggest disasters in the crypto industry. In fact, only Mt. Gox’s collapse can be compared to the devastation caused by Terra. While Mt. Gox was a smaller loss in dollar terms, its impact relative to the market is still in a class of its own.

Terra’s collapse was particularly bitter for UST owners. Luna can still be lumped together with others as a risky altcoin, but many saw UST as a safe haven in the market turmoil, comparable to the dollar or euro. Correcting this misconception became very expensive.

Social media is full of tragic stories one after another about people who have lost their savings. Some were able to take the big losses with humor – at least initially.

Fortunately, Terra’s hardcore fans (“Lunatics”) were only a small part of the entire crypto industry. The majority of investors did not touch UST or Luna. Whether or not you survived the crash with a clean slate, there are lessons to be learned.

First of all, stablecoins are not the same as fiat currencies. For example, Tether’s reserves have caused a debate for at least five years. Also, the stablecoin DAI got into a difficult situation in the March 2020 crash.

Stablecoins enable you to keep your fiat wealth in your wallet – at least in theory. In practice, they always carry the risk of the issuer. Both centralized and decentralized lending services also carry risks. There is no such thing as a risk-free return. Think carefully about how much of your portfolio you want to risk to earn interest.

One thing about Terra’s collapse surprised everyone. Its velocity. Not even the worst crypto scams like Bitcoinnect have collapsed so quickly. Both Luna and UST were in the top ten cryptocurrencies before the crash. Both became worthless in practically two days.

Terra’s collapse came at a bad time for crypto investors. Already six months into the downturn, it has taken away more than 50% of portfolios. Spring 2022 has been a tough school for investors. Everyone who has gone through it is guaranteed to be a stronger and smarter investor in the future.

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