TerraUSD (UST) Ecosystem Failure is a monumental event in the crypto world. The recent implosion of the TerraUSD (UST) algorithmic stablecoin and its protocol’s governance token, Luna, has sent shock waves through the entire digital asset ecosystem. TerraUSD is an algorithmic stablecoin that maintains parity to the US dollar through its algorithm, links to the Luna token, and arbitrage opportunities.
UST’s floating peg to the dollar on a 1UST to $1 basis began to falter on May 8, eventually breaking on May 9 and sending the token’s value on a death spiral. Attempts to stabilize the token through the sale of BTC reserves failed, crashing the price of the stablecoin to its current redeemable value of $0.06.
Many crypto specialists had earlier on issued warnings against algorithmic uncollateralized or under collateralized stablecoins such as Terra. They had warned that these stablecoins were fragile and were built to fail.
Besides the warnings, historical evidence attests to the high failure rate of algorithmic coins. Recent and prominent algo coin failures include Basis Cash, Empty Set Dollar, and Iron’s TITAN token failure in 2020.
Algorithmic stablecoins are an experimental technology.
Purely algorithmic stablecoins maintain their peg using game theory rules and software. They are algorithmic ‘Central Banks’ that combine embedded economic incentives with monetary supply, artificially reigning in the price of their stablecoins.
Most algorithmic stablecoin have a two-coin structure. One coin absorbs market volatility while the other maintains a peg to fiat, crypto, or commodity assets. The former is a ‘balancer’ token and can trade on crypto exchanges or participate in the yield crazed decentralized finance protocols.
Algorithmic stablecoins are the Holy Grail of the cryptosystem, settling their payments on-chain but maintaining price stability and purchasing power. They are alchemy minting their value from the projected future value of their network.
They mint both pairs of tokens at the project launch, then sell them at a discount to gain a competitive market edge. Unfortunately, this process saturates the entire ecosystem with devalued assets.
For this reason, many pundits have described Do Kwon’s attempt at building on experimental technology and attracting a large swath of retail users as ‘lunatic hubris .’Kwon Do-Hyung, aka Do Kwon, is a South Korean blockchain developer and the co-founder of Terraform Labs, the entity that runs the Terra blockchain.
Criticism against the Terra network
On September 2, 2021, Vitalik Buterin, the Ethereum visionary and co-founder, warned algorithmic stablecoin holders of the risks of these tokens.
Tweeting a reply about the long-term sustainability of algorithmic stablecoins, he said, “DAI/RAI-like stablecoins will be fine IMO! It’s all these new me-too VC-funded “innovations” at making stablecoins more “capital-efficient” or whatever that keep breaking and will keep breaking more.”
Then during a Bankless April 2022 episode, Vitalik warned that undercollateralized and barely collateralized stablecoin were “insanely risky” projects. “They are trying to market themselves on how optimal they are but without really caring about how fat their fat tails are,” he said.
Other critics of the algorithmic stablecoins include Dragonfly Capital’s, Haseeb Qureshi. Qureshi says that algorithmic stablecoins are a Schelling point “If enough people believe that the system will survive, that belief can lead to a virtuous cycle that ensures its survival.”
These experimental tokens can only sustain their peg within a certain projection of market behavior. Their peg will hold while some market conditions remain constant. Their stability relies on conditions that are impossible to predict or control, which include;
- high level of demand from hopeful users for operational stability
- independent actors who render price-stabilizing arbitrage to earn market incentives
- reliable real-time price information
The risks of the algorithmic stablecoin
The algorithmic stable coins’ competitive advantage grants their tokens a highly reflexive growth that could fade when the expectation of future market value begins to fade.
If their asset demand, for instance, falls below a certain threshold, the entire system will collapse. A demand crisis could instantly cause systemic failure in these tokens.
Secondly, a system whose stability is hinged on market-driven actors with no legal obligations on the performance of their price stabilizing function is easy to manipulate or attack.
Profit opportunities emerge when these algo coins slip too far from their peg. Arbitrage can be a self-accelerating and self-perpetuating risk, and an unbridled arbitrage system is an unavoidable death sentence.
Consequently, these coins present a massive incentive to attack their peg. Market players with little attachment to the crypto space will view them as low-hanging fruit.
Speaking about the market making the risk of algo coins in April 2022, Kevin Zhou of the Galois Capital hedge fund warned, “There’s a lot of these Chicago [traders], they don’t give a [damn]. If they see an opportunity, they’re going to Soros-attack it. They’re just waiting for the right moment … I think [UST] will collapse on its own, but if someone attacks it, it will collapse even faster.”
Kevin was right. The May 2022 Terra Luna crisis ensued when a large-scale speculator (whale) launched a liquidity attack on the network, causing FUD (fear, uncertainty, and doubt). This attack was the first bullet that led to the bloodbath that drained the ecosystem’s reserves.
Before its crash, the Terra network had over 6.5 trillion Luna in circulation. These governance tokens were selling at highs of $96 at their peak in late April 2022. They were worth over $41.2 billion. Unfortunately, these tokens have lost all that value.
The Luna UST crash is the most significant wealth destruction event by a single project in the sector’s project crash-ridden history. It wiped out over $60 billion worth of investor capital from the digital currency market.
It has been aptly named the crypto sector’s Lehman Bros moment. Lehman Brothers collapsed under a $60 billion loss in mortgage-backed securities. Likewise, Enron lost $65 billion while Bear Sterns had a $25 billion loss on its balance sheet.
The Terra Luna ecosystem’s $60 billion loss is in the magnitude of giants that played a key role in the 2008 global economic crisis.
The cost of lunatic hubris
Most pundits say that Do Kwon and his team could have halted the meltdown the first time the UST peg beamed a wobble in early May. But unfortunately, the team maintained a devil-may-care attitude due to blind lunatic hubris or a willingness to defraud the Terra ecosystem.
The team could have flagged the whale’s redemption of the $1 billion positions that they had built against UST on May 5. When he took note of the risk, on May 8, Do Kwon took to Twitter to reprimand the malicious attacker saying, “I’m up – amusing morning… Anon, you could listen to CT influencers about UST de-pegging for the 69th time. Or you could remember they’re all now poor, and go for a run instead”.
An arbitrageur set in to defend the peg that had slipped to $0.972 but could not keep up with the whale’s $650 million sell-off of cheap UST on Binance. Terra Validators could have tempered the ecosystem’s death spiral by halting their blockchain at the first sign of panic and bringing in specialists for troubleshooting.
Unfortunately, they held off their decision till May 12, when Luna and UST had lost most of their value. In its defense, Terra had begun to take note of its precarious position and kicked off its collateral acquisition process.
It made a series of BTC purchases that do not seem to have made much difference to the systemic failure of its protocols.
Risks of BTC as a reserve asset
Experimenting with the virtues of BTC as a reserve currency, the Luna Foundation Guard (LFG) purchased 80,394 BTC to shore up its token’s value. As a result, they had the second-largest BTC wallet bypassing Tesla’s trove. Moreover, their wallet came second after MicroStrategy’s 129,218 BTC reserve.
Do Kwon referred to the move as UST’s attempt to observe the Bitcoin standard. “It’s making a strong directional bet that keeping a lot of those foreign reserves in the form of a digital native currency will be a winning recipe,” he said.
Unfortunately, the Terra team made projections using an unpredictable asset. Bitcoin can function as a reserve currency in normal market conditions but will fail during times of volatility.
To illustrate this point, the Luna Foundation Guard purchased a 6,638.94 BTC stash on April 13, when it was retailing at the $42,000 range. Following the whale attack on UST, data by Elliptical, a Chain analysis firm, shows the foundation sold off over 80,000 BTC between May 8th and 10th at a $35,000 to $31,000 price range. The LFG reserve only has 313 BTC left.
External factors such as the Fed’s changing stance on interest rates were causing the crypto sell-off. As a result, BTC prices had plunged, and the LFG’s reserves were, therefore, lower than anticipated. The LFG’s massive sell-off further depressed the entire BTC market.
To aggravate the situation further, while the Terra network is decentralized, the LFG is a non-profit organization. Furthermore, it is centrally governed by a few officials and does not have an auditable paper trail.
The Elliptic report says that due to the pseudonymous nature of BTC transactions, they cannot determine the whereabouts of the assets after their Gemini and Binance exchange sales. The LFG confirmed the poor status of its reserves stating that it only owns 313BTC, 39,914 $BNB, 1,973,554 $AVAX, 1,847,079,725 $UST and 222,713,007 $LUNA.
Conclusion
A large majority of Luna token holders were retail investors who purchased these tokens when they were at their all-time high price of $100. These investors had rushed into the Terra ecosystem seeking the Anchor Protocol’s 19% yield returns on Luna holdings.
Likely, these ‘normies’ did not understand the risks of experimental, decentralized protocols that operate under centralized leadership. As a result, Luna has lost its intrinsic value, and there is little BTC reserve left to compensate Luna holder losses. Then the foundation liquidated an 80,394 $BTC reserve to prop a failing experimental project, an act of lunatic hubris.