Terra Collapse - AlwaysWealthy

Terra Collapse

On May 9th, 2022, the stablecoin UST lost its peg to the dollar and collapsed. The Terra collapse wiped out over $40 billion worth of value in a single week. It sent shock waves throughout the cryptocurrency market.

Terra is an algorithmic stablecoin that aims to maintain a peg to the US dollar. Unlike other stablecoins that are backed by US dollar reserves, Terra pegs itself to the US dollar through arbitrage opportunities with Luna.

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South Korean entrepreneur Do Kwon is behind Terra. He and his company Terraform Labs developed the Terra stablecoin and blockchain in 2018.[1] Pitchbook: “Terraform Labs Overview” Accessed May 24, 2022.

Terra received backing from several venture capital firms including Pantera Capital.

The project attracted the attention of many investors. This was partially due to the fact that Terra holders could lend their tokens on the Anchor protocol and earn up to 19.59% interest on their UST.[2] Anchor Protocol: “Earn” Accessed May 24, 2022.

Anchor protocol is a DeFi protocol. DeFi protocols allow people to engage with financial services like lending and borrowing without going through a central organization like a bank, broker or other financial institution.

How Terra Works

The Luna token works together with Terra stablecoins. There are several stablecoins that are pegged to different fiat currencies. But UST, also known as TerraUSD, is the most popular and widely used Terra stablecoin.

Luna should absorb the volatility of UST. Instead of maintaining its peg to the US dollar by backing each UST token with USD, Terra does this with arbitrage opportunities between UST and Luna.[3] Terralabs Foundation: “Terra Money: Stability and Adoption” Accessed May 24, 2022.

If demand for UST increases, more UST is created and Luna is burned. If demand for UST drops, more Luna is created and UST is burned. This balance act between the two coins should keep UST’s value stable.

Anchor Protocol and Terra Collapse

The Anchor protocol allows people to borrow and lend cryptocurrencies in the Terra ecosystem. Before Terra’s collapse, the annual interest rate for lending UST was 19.59%.

The borrower of UST would lock up collateral on the Anchor protocol in the form of Luna or another cryptocurrency.

These cryptocurrencies are then staked and go towards the 19.59% interest that is paid to lenders of UST. However, the staking rewards themselves aren’t enough to account for the high interest rate.

Some of the money for the interest payments comes from reserves on the Anchor protocol. Should these reserves run out, Anchor would become insolvent.

This led some to believe that the Anchor protocol operates similar to a Ponzi scheme.[4] Cryptobriefing: “Terra’s Do Kwon Investigated for Running a Ponzi: Report” Accessed May 24, 2022. The Terralabs Foundation has to come up with the difference to maintain the high interest rates. Some have speculated that Terraform Labs achieves this with new user funds, which in return are attracted using the promise of high yields.

One of the main benefits for someone to hold UST instead of USD is the interest they can earn. Traditional savings accounts pay less than 1% these days.

The high yields on Anchor attracted a lot of investors and incentivized them to hold UST. But the high yields weren’t sustainable long-term, making Anchor and UST susceptible to bank runs.

Traditional Bank Runs

Bank runs are common in the traditional financial system. In a fractional reserve banking system, banks only keep a small percentage of funds on hand and lend out the rest.

If a large number of depositors withdraws their money at the same time, banks don’t have enough funds to pay all depositors.

These types of bank runs were common even before the 19th century. They played a major role during the Great Depression and Global Financial Crisis of 2008.

In a similar way, issuers of stablecoins don’t necessarily back their stablecoins to 100% with the currency they are supposed to be convertible into.

If a stablecoin issuer backs each token with one US dollar, a bank run would be unlikely or at least not cause any problems. Anyone who wants to redeem their stablecoin can do so.

Since one dollar backs each stablecoin, a crisis of trust and a run on the stablecoin wouldn’t break the peg. The intrinsic value of each stablecoin remains $1 due to the full backing.

But if a stablecoin issuer only backs each stablecoin with $0.30, a run on the stablecoin would mean that not all holders can redeem their tokens for dollars.

Runs of Algorithmic Stablecoins

Algorithmic stablecoins like Terra aren’t backed by US dollars. Instead, they rely on complex algorithms and arbitrage opportunities designed to maintain the stablecoin’s peg.

This can make an algorithmic stablecoin prone to attacks. It is also more fragile than a fully backed and collateralized stablecoin.

In 2021, Terra founder Do Kwon began purchasing bitcoin as a reserve asset for Terra. However, the total value of Terra’s bitcoin reserves only amounted to a fraction of UST’s market cap.[5] Bloomberg: “King of the ‘Lunatics’ Becomes Bitcoin’s Most-Watched Whale” Accessed May 24, 2022.

More bitcoin purchases and a sharp increase in the price of bitcoin could have eventually increased UST’s backing. As long as the total value of Terra’s bitcoin reserves matched or exceeded the market cap of UST, the bitcoin reserves could reduce the risks of a run on UST.

Nevertheless, it is not the same as backing UST with US dollars. In case Terra was fully backed by US dollars, it would act similar to Circle and Coinbase’s USDC stablecoin.

But in that case, Terra wouldn’t need to rely on algorithmic price stability anymore.

Terra Collapse and Death Spiral

On the 9th of May 2022, Terra lost its peg to the US dollar. A few large holders withdrew hundreds of millions of dollars worth of UST.[6] Kitco News: “A ‘short attack’ caused UST de-peg, Luna’s 97% price collapse, so who was responsible?” Accessed May 24, 2022. Some have speculated that this was an intentional attack on the Terra stablecoin, but this is unconfirmed.

As hundreds of millions of dollars worth of UST left the Terra ecosystem, this caused an imbalance and led to a bank run on Anchor.

Terra collapse
Chart of Terra collapse by TradingView

The imbalance led to arbitrageurs redeeming UST for Luna and then selling Luna. This triggered a reflexive downwards spiral, known as a “death spiral”.

The sale of Luna reduced its price, this in turn made it necessary to mint more Luna. The result was a hyperinflation in the supply of Luna.

As the de-pegging continued, the value of both UST and Luna dropped significantly. This intensified the run on UST and Luna, eventually rendering both tokens almost worthless.

Bitcoin Reserves

As the “death spiral” continued, Do Kwon sold most of the Luna Foundation Guard’s bitcoin reserves.[7] CNBC: “$3 billion in bitcoin was sold in a last-ditch attempt to save UST stablecoin from collapse” Accessed May 24, 2022. These efforts were ultimately not sufficient to stabilize UST’s price and maintain its peg to the US dollar.

Since UST wasn’t fully backed by US dollars, the amount of US dollars that could be extracted from Luna and the sale of bitcoin reserves was limited.

As people got rid of their Luna and Do Kwon sold bitcoin, this put downward pressure on the price of both Luna and bitcoin, further reducing the amount of US dollars that could be extracted from selling Luna and bitcoin.

As of May 24th, 2022, UST was trading at $0.067 and Luna was trading at $0.00016, down from its high of over $115.

Terra Fork

On Monday, 16th of May, Do Kwon proposed to revive the leftovers of the Terra ecosystem. The proposal included a hardfork of the Terra blockchain.

This would result in a chain split. The old Terra blockchain, on which the UST stablecoin relied, would become Terra Classic.

The new blockchain, called Terra, would continue to exist but without the algorithmic stablecoin. The Terra community rejected the initial proposal. Do Kwon put other proposals forward, but the trust and reputation of the Terra ecosystem wasn’t in good standing.

Effects of Terra Collapse

Many investors lost money during the Terra collapse. Even funds and institutions that held Terra or Luna experienced major losses.

Suicide messages from distressed retail investors circulated on Reddit and Twitter. At some point, the pinned post in Terra’s main Reddit board was the national suicide hotline.

Terra’s crash also impacted decentralized applications (dApps) built on top of the Terra blockchain. Developers built many secondary projects on top of Terra and used its native UST token.

This showed that the collapse of Terra posed systemic risks for large parts of the DeFi ecosystem. At its peak, Terra was the second-largest DeFi network. Given its large market cap and wide-spread use among investors and builders of decentralized apps, the implications of Terra’s collapse are significant.

Terra’s collapse received attention from mainstream media, including comments from Janet Yellen.[8] Bloomberg “Yellen Says Terra Meltdown Shows Crypto-Stablecoin Dangers” Accessed May 24, 2022. Regulators have long expressed concerns about stablecoins. The collapse of Terra led to renewed calls for regulating stablecoins.


Critics of Terra had pointed out before its collapse that it wasn’t sustainable. Some called it a Ponzi scheme. Others warned that Terra would eventually fail, similar to other algorithmic stablecoins like Iron.

Several people had challenged Do Kwon on Twitter and even betted that Terra would eventually collapse.[9] The Defiant: “Degen Who Slammed Terra as ‘Ponzi’ Dares Founder to Bet $1M on LUNA — and He Did” Accessed May 24, 2022.

Despite warnings from critics, Terra and Luna wre among the most popular cryptocurrencies beginning of 2021. Mike Novogratz, founder of Galaxy Digital, famously had a Luna tattoo on his arm.

The collapse of Terra shows that some of the same risks that exist in the traditional financial system, including bank runs, also exist in the cryptocurrency market.


May 24, 2022