One of the biggest collapses in crypto history happened last week.
Terra ecosystem is a protocol that has two coins: UST and LUNA. The first one was a stable coin that tracked the fiat currency price and maintained its price to $1 with an algorithm that worked with LUNA, which provides staking, rewards, and governance power.
Thanks to the popularity of an excellent stable coin with a promising backed project, the terra ecosystem expanded its project to build decentralized applications and create a trusted platform for millions of users that quickly developed a demand for Terra and increased the price of LUNA to more than $100.
However, the past Monday, the UST protocol lost its peg and dropped its stability to less than $0.10, while LUNA crashed by over 98% in a few days to reach less than $0.01, making millions of people lose their life savings in less than a week.
This article will explain how this happened and why nobody expected it.
Terra’s mission was to bring a trustworthy and reliable stable coin solution to the crypto world, which was pegged 1:1 to the value of the US Dollar. 1 TerraUSD ($UST) can always be redeemed for 1 US Dollar worth of their token $LUNA as collateral. The official documentation explained how the two coins worked to create this dynamic:
Imagine the whole Terra economy as two pools: one for Terra and one for Luna. To maintain the price of Terra, the Luna supply pool adds to or subtracts from Terra’s supply. Users burn Luna to mint Terra and burn Terra to mint Luna, all incentivized by the protocol’s algorithmic market module.
Basically, the algorithm worked this way: you can trade 1 UST for 1.01 USD, and the protocol burns 1 USD and mints 1 UST, then they can sell their 1 UST for 1.01 USD, profiting .01 USD through arbitrage, adding to the UST pool (and the same vice-versa with 0.99 USD to 1 UST). This arbitrage continues until the UST price goes back to match the USD price, maintaining Terra’s peg.
The final goal of Terra was to offer a completely stable coin well backed regardless of the market size, volatility and demand.
The opportunities were endless by using software programs to manage the token’s volatility. Companies like Anchor Protocol offered users a 20% annual return risk-free to traders that staked their UST on its platform.
Everything was so perfect that thousands of people decided to trust all their money there. At its peak, Anchor Protocol held more than $14 Billion $UST (70% of all $UST in circulation):
The problem was that Terra only had $2.5 Billion worth of assets in their vault to back the ecosystem. This was not enough gunpowder to defend the protocol if any issues appeared.
An anonymous person (or group) took out a loan of $350MM and started shorting UST, dumping it onto the open market. His goal was to buy back cheaper and return what he borrowed. With a flood of selling slamming the market, the Terra ecosystem came under tremendous pressure, and UST began to lose its peg, dropping down to as low as $0.80 on the first day.
The biggest issue was when all the people started panicking (most people had their life savings there), so they also started selling their money to avoid losing everything.
To drive the peg back up to $1, Do Kwon, the owner of terra, needed to sell the reserve assets held in the Terra vault. He started dumping Bitcoin and other cryptocurrencies on the open market, causing them to tumble. He could not keep up. The flood of selling was too much, so everything collapsed.
In the next 24 hours after this attack, UST went from 0.80 to 0.05, while LUNA went from $80 to 0.01:
On Friday, Binance decided to unlist LUNA and UST from their platform because of the high risk that the coins were representing, making everything worst.
People started panicking to the point that there were many Reddit threads about mental health, people going crazy, and how they could handle that mess and find professional help. Terra even decided to close their direct channels.
It is estimated that the attacker closed their short position and profited $815mm, and it’s still unknown his name.
According to a forum post, a group of dApp developers in the Terra ecosystem created a proposal to relaunch the project “to honor existing UST holders, loyal Luna holders, and developers.” There are also other proposals to distribute an airdrop to Luna and UST holders.
Do Kwon was also planning to fix the algorithm and launch a Terra 2.0 project.
However, they will have to work hard to recover the trust of the thousands of people who lost their money in the last seven days.
The decline of Terra is probably one of the biggest collapses in crypto history until now. The ecosystem went from a $60 billion market cap to almost $0 in less than seven days.
I lost 20% of the money I had invested there, but I learned several lessons by observing the panic and making decisions in moments of despair. This is what I was able to get out of this tragedy:
- There is no risk-free investment. Anchor offered 20% interest on a “stable coin” on a good project well-backed. Everything seemed too good and reliable, but we can’t put all our money and faith into a project or company just because we see it too good and trustworthy.
- Always have an exit plan. No matter how much faith and hope you have in a company, always secure your money in times of collapse. It can go back all it wants, but try to put your financial stability first. I sold at $0.9 because I didn’t feel like I should risk the money I had there because of unsure faith, and it was the best decision I could make in times of desperation.
- Take profit. Many of the desperate moments that many people have now are due to not taking profit in times of abundance. If you withdraw your initial investment of every investment, there will be no fear of losing the money that you will need.
Author: Desiree Peralta