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The $60B Fall of Terra Worsened the Bear Market and Undermined DeFi
By: Rahul Nambiampurath
Terra was one of the blockchains based on the scalable and open-source Cosmos framework. Because Cosmos architecture allows far greater transaction speed and scalability than Ethereum, Terra became a top contender as an “Ethereum killer”.
This all ended one of Terra’s key products, the TerraUSD (UST) stablecoin, depegged during rough market conditions in May 2022. Terra’s collapse, which vaporized about $60B worth of crypto market capitalization, made the project the byword for crypto failure during the 2022 bear market.
Now Terra, much like Lehman Brothers in TradFi, has become a cautionary tale. As a result, it’s important to understand what it was designed to do and why it failed.
In January 2018, South Korean software developer Do Kwon, together with venture capitalist Daniel Shin, co-founded blockchain startup Terraform Labs in Seoul. A year later, they launched the network’s native cryptocurrency, LUNA..
Do Kwon’s goal was to use the Terra blockchain to deliver stablecoins to every major network. Although it may appear that the Ethereum-based DAI stablecoin already serves that purpose, Kwon thought he could do it better by fixing its deficiencies.
Because DAI stablecoin can be locked in lending dApps like Compound as a collateral, this restricted its supply and led to a premium DAI price against the dollar. For this reason, Kwon wanted to deploy a stablecoin that has a dynamically contracting and expanding market supply — an algorithmic stablecoin.
This allowed the stablecoin to remain close to the dollar’s one-to-one ratio. It also enabled greater dApp scalability with global crypto adoption. In September 2020, Terra Labs launched this algorithmic stablecoin as TerraUSD (UST) on the Bittrex Global exchange.
Terra’s blockchain was built with Cosmos SDK (software developer kit). Terra shared its architecture with the Cosmos ecosystem of blockchains. Specifically, it used Tendermint Delegated Proof of Stake (DPoS) consensus.
Alongside validators to process transactions and add them as new data blocks, Terra used delegators. They selected validators to earn a portion of validator’s block reward, as staked LUNA tokens. If validators went against the protocol, both validators and their delegators lost staked LUNA.
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Tendermint Core was a Byzantine fault-tolerant (BFT) consensus algorithm that protected the network from double-spend attempts and delivered tolerance up to 33%. This means that 33% of network actors (validators) had to be subverted before a transaction could be falsified.
Tendermint boosted this resistance thanks to bonded deposits. Because they have to be unlocked, deposits have a three-month unbonding period. Such a redundancy gives plenty of warning time to delegators to switch validators.
Ultimately, this made a Cosmos-based network more secure because any attack has both a cost and is telegraphed well in advance. Like other Cosmos-based blockchains, Terra had a near-instant block finality time, up to three seconds, which made it an enterprise-grade network comparable with Visa.
At its peak, Terra’s total value locked (TVL) hit $21.7B in May 2022. Terra made nearly 15% of DeFi market share. This was the closest any competitive chain came to disrupting Ethereum’s longstanding market dominance.
Likewise, both Terra’s native token, LUNA, and UST ranked in the top 10 cryptocurrencies, with LUNA peaking at almost $41B in April 2022 nd UST at $19B the following month.
Unfortunately, Do Kwon relied on a slippery monetary mechanism. To understand how we need to explore the seigniorage concept.
How much does it cost to produce a banknote, such as $100? The difference between that cost and the value of that banknote is seigniorage. In other words, it’s the difference between the production cost and nominal value that delivers the true value of currency.
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Kwon applied the seigniorage principle to capture value with an algorithmic stablecoin. He used a dual minting/burning mechanism between LUNA and UST:
In other words, LUNA absorbed the algorithmic stablecoin’s volatility and allowed it to not backed by actual USD, which we see in classically collateralized stablecoins like USDT and USDC.
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A multi-collateralized stablecoin like DAI is overcollateralized to maintain its peg to the dollar. That’s why DAI seigniorage was high, while the UST seigniorage was minimal, which made it more scalable.
Because UST depended on LUNA, Terra’s governance and utility token experienced phenomenal appreciation. This was additionally spurred on by one of Terra’s key dApps — Anchor Protocol. Like other lending dApps, Anchor was based around a simple concept:
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The problem was that Anchor Protocol set its interest rate artificially high to entice user inflow, at 19.5%. This created a massive platform vulnerability which eventually collapsed. After all, such high yields could only be served by constant user uptake, not within Terra’s ecosystem itself. That’s why many marked the Anchor Protocol as a Ponzi scheme.
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Terra’s entire ecosystem was reliant on LUNA maintaining its price, or at least, not suffering severe price depreciation. Well aware of this vulnerability, the Luna Foundation Guard (LFG) started bolstering the UST peg with Bitcoin in tandem with LUNA support.
Terraform Labs had established LFG to manage assets and grant funds to grow Terra’s ecosystem. LFG, for example, had given a grant to Anchor Protocol.
When LUNA started tumbling during the bear market, many investors withdrew funds from the Terra ecosystem, led by Anchor. This cascaded into a classic bank run, deepening the broader selloff across crypto.
The weakness in the model was already visible in February 2022. An Anchor community member going by the moniker “N3m0” asked LFG to bolster Anchor reserves with $450M to shore up declining revenue. Anchor’s stablecoin yield was so high (up to 20%), that it became unsustainable without the constant broadening of the pyramid’s bottom.
Critics branded this business model a classic Ponzi scheme. In Terra’s governance forum, N3m0 forecasted that Anchor would run out of stablecoin yields in November. It turned out the fall came much sooner.
When LUNA started tumbling during the bear market in the spring, many investors withdrew funds from the Terra ecosystem, led by Anchor. This cascaded into a classic bank run, deepening the broader selloff across crypto.
Within less than a week, from May 5 to May 11, LUNA’s price cratered to fractions of cent from $65. LUNA collapsed.
As soon as LUNA collapsed, UST soon followed. Although the LFG deployed $1.5B ($750M to BTC and $750M to UST) on May 9 to defend the stablecoin peg, it was too late.
In the aftermath, Terra blockchain hard-forked into Terra 2.0, leaving behind the defunct UST, and LUNA became LUNA Classic (LUNC).
Meanwhile, South Korean prosecutors have raided Terraform Labs, and issued an Interpol “Red Notice” arrest warrant for Do Kwon, whose whereabouts are unknown. In a recent interview on Unchained Podcast, Do Kwon denied he was a fugitive.
This series article is intended for general guidance and information purposes only for beginners participating in cryptocurrencies and DeFi. The contents of this article are not to be construed as legal, business, investment, or tax advice. You should consult with your advisors for all legal, business, investment, and tax implications and advice. The Defiant is not responsible for any lost funds. Please use your best judgment and practice due diligence before interacting with smart contracts.
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