UST is an algorithmic stablecoin that is supposed to stay pegged to the US dollar at $1. This means, 1 UST should always be convertible into 1 USD. However, in recent days, the stablecoin broke its peg and plunged to $0.14, losing its parity and wiping out over 85% of its value. In this article, I break down what happened during the recent and dramatic Terra Luna crash.
Maintaining a stablecoin is pretty simple, at least in theory. If you want to guarantee that someone can redeem your stablecoin for $1, you need to collateralize each unit of stablecoin with $1.
This means, if every UST were backed by one USD, there would be enough dollars to redeem every single holder of the stablecoin.
However, whenever a stablecoin issuer only holds a fraction of the stablecoin’s value in the form of dollar reserves, a “run on the stablecoin” results in there not being enough dollars to redeem all units of the stablecoin.
This problem is common in the banking system as well. Under the fractional reserve banking system, banks only keep a small fraction of people’s deposits on hand and lend out the rest.
If too many depositors try withdrawing their funds at the same time, banks cannot honor the withdrawals and go bankrupt. These types of bank runs due to a lack of reserves were common until the Great Depression.
In fact, the Federal Reserve was founded to help stabilize the fractional reserve banking system. However, it appears that even a hundred years later, unsound financial practices are still in full rage, whether its banks, government sponsored enterprises or DeFi protocols.
Unlike stablecoins like Tether or USDC, which are backed by actual US dollars, Terra is backed by a token called LUNA. Just to be clear, Terra and UST are the same thing and I will use these terms interchangeably throughout this article.
What makes Terra unique is that it isn’t backed by US dollars at all. However, the promises is that holders of Terra can convert 1 UST into 1 USD at anytime.
But how is that possible if Terra isn’t backed by dollars at all? This is where the token LUNA comes into play. The name of Terra’s official Twitter profile is: “Terra (UST) Powered by LUNA.”
This gives us a hint at how Terra works. Instead of backing each Terra token with actual dollars, Terra is backed by the LUNA token.
You go to a crypto exchange and deposit US dollars. With those dollars, you can purchase Terra (UST). The idea is that if you have 1 US dollar you can purchase 1 UST.
Let’s say you buy 100 UST for 100 US dollars. If you ever want to exchange your UST back into dollars, you would redeem your 100 UST for 100 US dollars worth of LUNA. And finally, you can exchange your LUNA back into US dollars.
This is a bit complicated to understand but the key point is that when you want to sell UST, you need to first convert it to LUNA.
If the price of LUNA is $100, you would convert your 100 UST and get 1 LUNA token. You would then sell this LUNA token for 100 US dollars. If the price of LUNA were $10, you would receive 10 LUNA tokens in return for 100 UST.
You get the idea. So in theory, if there are enough LUNA tokens to back Terra (UST), everything should be fine, right? Not really. As of end of April, the market cap of UST was $18.5 billion and the market cap of LUNA was $28 billion. So it appears as if Terra is overcollaterized by LUNA.
It seems as if even if 100% of Terra holders want to get their money out, there would be plenty of LUNA to pay out everyone. This is a flawed assumption though, since the price of LUNA crashes as soon as people start selling UST.
If lots of people sell UST at the same time, they will convert them into LUNA tokens. The way the algorithm works is somewhat complex. But if a lot of people want out at the same time, the LUNA token starts crashing.
The first few people that redeem their UST for LUNA get the original US dollar price of LUNA of let’s say $100. But as selling pressure increases, the value of the LUNA token crashes.
In reality, only a US dollar amount worth a fraction of LUNA’s market cap can be pulled out of the market if everyone wanted to redeem their UST for US dollars at the same time. Even if LUNA has a 2X or 3X market cap compared to UST, this doesn’t mean the stablecoin is sufficiently backed.
It’s a very fragile setup to say the least. When more UST want to leave the system than there are US dollars extractable from LUNA, the stablecoin looses its peg.
As a result of this weakness, the Luna Foundation Guard began aggressively accumulating bitcoin as an additional reserve. The idea was that if there aren’t enough USD that can be extrated from LUNA, the Luna Foundation Guard could sell its bitcoin to get dollars.
This would, so the idea, allow Terra to “defend” its peg in case LUNA didn’t hold up. The Luna Foundation Guard bought $3.5 billion worth of bitcoin and put it in its reserves.
When the Luna Foundation Guard began buying bitcoin, some asked, why would they need bitcoin if the peg is supposed to be maintained algorithmically? In fact, as far back as 2018, critical observers called UST a highly unstable project or downright a Ponzi scheme.
The reason some call Terra a Ponzi scheme is because UST holders could earn almost 20% yield on the Anchor protocol. This made it very attractive to buy and hold UST. Who wouldn’t want to earn 20% annualized on their dollars when even high-yield savings accounts rarely pay 1% these days?
With the high yields, Terra could reel in new people and guarantee a steady increase of UST supply from newcomers. But how were the high yields paid? Through additional UST that entered from other newcomers.
Moreover, a similar algorithmic stablecoin called Iron, with its counterpart Titan, lost its peg and collapsed. Critics pointed out a Terra Luna crash would be guaranteed sooner or later, similar to how Iron and Titan crashed. But few people listened.
Now that you understand the weaknesses of the Terra Luna ecosystem, and the Ponzinomics it depends on, it’s easy to see how a speculator could attack Terra and make a profit.
There are unconfirmed rumors that a large player like Citadel is behind the recent Terra Luna crash.
Whether or not it was Citadel, or some other Wall Street Firm, doesn’t matter at this point. Back in the early 90s, American billionaire George Soros launched a speculative attack against the Bank of England.
He and other investors shorted the Pound sterling with over $10 billion. Knowing that the Bank of England wouldn’t have enough reserves to buy back the sold pounds and counteract the attack, the Bank of England had to devalue the pound by 15%. Soros, who was shorting the pound, made a handsome profit doing this.
In a similar way, it appears as if someone launched a Soros-type attack on Terra. Onchain data suggests that two addresses dumped hundreds of millions of dollars worth of UST, setting the Terra Luna crash in motion.
The Luna Guard Foundation recently faced low liquidity due some internal changes. At the same time, the foundation began accumulating bitcoin.
These two pieces are important to understand the attack. Knowing that Terra temporarily faced low liquidity, and knowing that the Luna Guard Foundation would sell bitcoin to defend the peg, the attacker proceeded as follows.
The attacker took a short position in the form of 100k bitcoin, or approximately $4.2 billion. At the same time, the attacker purchases a large amount of UST.
The Luna Guard Foundation removes $150 million in liquidity (as part of internal changes related to something called “4pool”). The attacker then dumps his $350 million worth of UST.
This starts the de-pegging process. The Luna Guard Foundation then begins selling bitcoin to defend the peg. This puts downward pressure on the bitcoin price.
Once panic began spreading among retail investors, the attacker sells another $650 million worth of UST. The de-pegging continues and people flee the Anchor protocol and convert their UST into LUNA.
As the price of UST crashes, the price of LUNA crashes as well (see earlier). This creates a death spiral where the falling price of UST pushes down the price of LUNA and vice versa. The bank run and panic is in full motion at this point.
Finally, the attacker could sell most of the UST while the peg was still in tact and US dollars could be extracted from LUNA. This means, the attacker didn’t make a significant loss dumping UST.
Having a short position in bitcoin, the attacker then made a handsome profit as the bitcoin price crashed 25%. The Luna Guard Foundation sold their bitcoin reserves to defend the peg. As bitcoin plunged, the market as a whole panicked, putting further downward pressure on the bitcoin price.
It is estimated that an attacker in this scenario made around $800 million in profit. However, it is important to note that who the attacker was and whether the attack really unfolded this way is still speculation. More information will surely surface in the coming days and weeks.
This Soros-style attack, if it truly took place this way, caused the recent Terra Luna crash. It’s most likely also to a large extent what got the bitcoin price plummeting this much.
High inflation numbers and the Fed’s monetary policy surely didn’t help either. The conditions for the attack and for taking a short position in bitcoin were perfect.
The aftermath isn’t pretty though and whoever caused the attack, if it truly was one, acted unethically. The top pinned post in the Luna Guard Foundation’s Reddit board is the national suicide hotline.
Most of the recent posts on Reddit are from people who lost all their life savings. Twitter and Reddit were full of suicide talk. And not just talk. Apparently, the recent Terra Luna crash triggered a wave of suicides among retail investors who had their savings invested in the Terra Luna ecosystem.
Furthermore, it shows us that stablecoins are only stable if they are backed to 100% with the actual thing they are supposed to be redeemable for.
A stablecoin that promises convertibility into US dollars needs to be backed to 100% with dollars. Every single stablecoin, redeemable into 1 USD needs to be backed by 1 USD. A stablecoin redeemable into gold needs to be backed by the equivalent amount of gold.
We need to learn from the weaknesses of the fractional reserve banking system instead of magnifying them. Cryptocurrencies need to be treated with caution.
Bitcoin and altcoins aren’t created equal and have totally different risk profiles. For example, coins that are backed by VCs and are pushed with large marketing budgets using social media influencers should be observed and treated with caution.
It’s easy to hype up a project with a large marketing budget and social media influencers. In the case of the Terra Luna crash, it shows that even repeated warnings since 2018, outright challenges and bets against Do Kwon and failures of past projects like Iron and Titan aren’t enough to prevent history from repeating itself.
Finally, the Terra Luna crash showed that Decentralized Finance (DeFi) isn’t decentralized at all.
The Terra blockchain was halted two times during the token’s crash. How can you halt a decentralized blockchain? You can’t. This is only possible, especially so fast, if there is central leadership and control.
Terra’s official Twitter account tweeted:
The Terra blockchain has officially halted at block 7607789. Terra Validators have halted the network to come up with a plan to reconstitute it.
Terra on May 13th
Most DeFi protocols market themselves as being decentralized, but they aren’t. They’re controlled by the founders and venture capitalists running the companies, organizations and foundations promoting the protocols.
We need more serious education and critical discourse around cryptocurrency as a whole. We need a distinction between ICO and VA-backed cryptocurrencies and bitcoin.
My heart goes out to everyone who lost a lot of money in the terra luna crash. Let’s learn from this experience and not repeat the same mistakes again.