Why Terra Luna collapsed in just a few days

Why Terra Luna collapsed in just a few days

Why Terra Luna collapsed in just a few days

Investors often cite the blowup of Lehman Brothers in 2008 as the opening shot in the long and dreary recession that was the great financial crisis. At its peak Lehman had a market cap of $60 billion, making it not that much larger than Terra in its final moments.

A week ago Terra had a market cap of $29 billion and UST a market cap of $18 billion. Together the two coins had a combined market cap of $47 billion, making them massive projects by anyone’s standards. With all of that capital locked up, Terra didn’t just randomly blow up one afternoon. Sophisticated and well-funded traders took down the project by pushing on its greatest weakness: a lack of collateralization. Here’s what happened.

To create the UST stablecoin an investor has to buy the LUNA token and burn it. Over time this reduces the supply of LUNA and drives the token’s price up. Conversely, to get a redemption a trader can burn UST and mint a corresponding amount of LUNA. The attackers knew that if they broke UST’s dollar peg, the depegging would create uncertainty in the ecosystem and cause a cascading and ruinous series of UST redemptions.

On May 7th the attackers swapped $85 million worth of UST into USDC on the decentralized exchange Curve (a detailed analysis on the attack vector is available here). The attacker, or attackers, then continued to swap tens of millions of dollars worth of USDC, putting constant downward pressure on the price of UST. Initially the peg held around $0.98, and for a few hours it seemed like everything was going to be fine.

As the attack continued, however, sentiment turned negative. Investors withdrew several billion dollars worth of UST from Anchor and began to redeem their tokens for LUNA. This pushed LUNA’s price down, leading to more instability. The further that UST depegged from the dollar, the more investors redeemed their stablecoins and exited the Terra ecosystem.  

Ongoing redemptions eventually led to Terra’s demise, marked most obviously by the point at which the market cap of LUNA dipped below the market cap of UST. Once that happened it became clear that not everyone would be able to redeem their UST, ending any illusions of Terra’s recovery.

As this article is being written, LUNA has a circulating supply of about 7 trillion tokens, and that number is continually increasing. Just prior to the attack, the LUNA token had a circulating supply of a scant 350 million tokens. LUNA is trading at a fraction of a penny, effectively a total loss for anyone still holding the token.

What are the broader implications for the cryptocurrency ecosystem? Well, Terra had about $1.8 billion worth of BTC which they sold in a failed attempt to defend the peg. That partially explains the large dip we just experienced in the markets.

Looking to the future, it’s likely that this cataclysmic blow-up is going to attract the attention of regulators. Janet Yellen has already mentioned Terra’s meltdown and the SEC will probably release a statement soon as well.

Is there any chance that Terra can recover? It’s very unlikely. The project depended on the trust that people put into it, and that trust is gone now. That’s disappointing on many levels, not the least of which is a serious need for a stablecoin with an unlimited supply. Not in a hyper-inflationary sense, but in a supply and demand sense. DAI is limited by the number of investors willing to deposit collateral to mint new tokens. The same goes for USDC.

The latest news suggests that Terra founder Do Kwon will compensate Terra community members by distributing 1 billion tokens to token holders who were unable or unwilling to sell their UST or LUNA tokens during the crash. Ten percent of this distribution will go towards Terra’s development pool, but Kwon also wrote that:

​​"Even if the peg were to eventually restore after the last marginal buyers and sellers have capitulated, the holders of Luna have so severely been liquidated and diluted that we will lack the ecosystem to build back up from the ashes."

Terra’s UST token was an attempt to free stablecoins from the conundrum of limited supply, and the project’s failure is a big blow both financially and in terms of the continued expansion of digital assets. This is a sad time for the blockchain community and we are truly sorry for anyone who lost money in this unprecedented meltdown.

This content is for informational purposes only and is not investment advice. You should consult a qualified licensed advisor before engaging in any transaction.

Get insider crypto knowledge and product updates from the world’s leading crypto wallet
Sign me up