Understanding The Terra Tumble
Terra (LUNA) is a blockchain protocol for issuing algorithmic stablecoins and creating decentralized financial infrastructure. To accomplish its basic premise as a stablecoin platform, Terra uses a seigniorage model that minimizes volatility to keep a close fiat currency peg.
Terra has two significant components. Terra is the blockchain protocol for issuing algorithmic stablecoins pegged to any regional denomination. Luna is the protocol token used to stake and govern Terra while also locking value into the Terra ecosystem.
Terra has created a mechanism that issues regional stablecoins that can also be swapped easily. Still, the catch here is that Terra stablecoins are not backed by dollars, Korean won, or any other fiat currency, for that matter. Instead, Terra issues crypto-collateralized algorithmic stablecoins. These stablecoins hold a pegged value using a circular dual-token system that creates arbitrage opportunities via seigniorage.
While this sounds confusing, Terra has two fundamental mechanisms to keep stablecoins stable.
a) Luna - Luna is the governance token that helps stabilize and collateralize the price of Terra Stablecoins, TUSD, TerraKwon and others.
Even when the market price of UST isn’t $1 per token, the conversion rate for minting treats 1 UST as equal to $1. Thus to mint Luna, one needs to burn Terra and vice versa.
The mechanism automatically corrects the supply to close such mishandling in an arbitrage opportunity. For example, if a trader sees that Terra is trading for $0.98, they may decide to buy $100 worth of Terra, and since 1 UST = $1 when exchanging Terra for Luna, the person would get $100 worth of Luna, marking a profit of $2 worth of Luna.
The increased demand for UST by arbitrageurs increases UST’s price. Terra burns the UST during the exchange to LUNA, reducing its supply and increasing UST’s price. Once 1 UST reaches $1, the arbitrage opportunity closes.
Something similar would happen when the price of Terra goes beyond $1. But in this case, Luna tokens would be burnt so that the supply of Terra increases, correcting the price to $1.
b) TerraSDR - It is the basket of currencies that are collateralized by the Luna tokens. TerraSDR is pegged via Band oracles to the price of the IMF SDR — a special asset made up of a weighted basket of currencies (USD, EUR, YEN, GBP, RMB). Because the SDR is composed of globally important currencies, it creates a non-volatile reference point for TerraSDR.
When the price of 1 TerraSDR = .95 SDR, one can send 1 TerraSDR to Terra’s smart contract to receive 1 SDR worth of LUNA. This reduces the supply of TerraSDR to boost its value back to parity with SDR.
Understanding The Collateralization
Terra’s UST is not backed by external collateral but by another token from its ecosystem, LUNA. This means that the value and liquidity of LUNA essentially serve as the “backing” of the system, as it determines the capacity in which UST holders can exit. This is what is made Terra novel in its approach toward stablecoins because stablecoins like MakerDAO’s DAI derive their collateralization from users holding a basket of Ethereum-based assets into a smart contract to maintain DAI’s peg to the U.S. dollar.
Now, let’s try to simplify it further. Since we’ve taken the example of DAI here, what we need to understand is the asset which collateralizes it needs to be traded and has to create some value to lend the same to the stablecoin, and in this case, since it’s a basket of multiple tokens based on the Ethereum protocol, each serves its own purpose and has healthy trading volume. Even if one of the project/protocol these token serves tend to break down, the risk is mitigated to quite an extent due to the multiplicity of the nature of this basket and thus not hurting the stable coin to a large extent.
Now, what happened with Terra is that since it’s collateralized only with LUNA, users need to find some value out of LUNA and also, the same needs to have healthy trading volume and liquidity. Ideally, LUNA’s only purpose is governance token and to secure the Terra blockchain.
Luna Foundation Guard
Do Kwon, the co-founder of Terra, set up a non-profit based in Singapore called the Luna Foundation Guard, or LFG. It is described as a ‘decentralized [foreign exchange] reserve’, but what makes it interesting and worrisome is that it does not back UST while it is a reserve. For more perspective, think of it as a bailout fund.
LFT had been raising enormous amounts of funds — mostly in bitcoin — to serve as a “forex reserve” for UST.
In February, LFG had raised $1 billion to form a bitcoin reserve for UST. In March, Do Kwon revealed that LFG upped the number to $2.2 billion for its bitcoin reserve and had a long-term goal of $10 billion. In April, it added $100 million in AVAX tokens (Avalanche’s Native Token) and $231 million worth of bitcoin. On May 5, LFG said it had purchased $1.5 billion worth of bitcoin, bringing the total in reserve to $3.5 billion.
As per a proposal submitted to the Terra research platform, LFG would transfer the UST reserve assets to a dedicated reserve pool. According to the proposal, this reserve would be accessible only in “emergencies but not otherwise,” according to the proposal. The suggested threshold was $0.98 – i.e., if things deteriorated to the point where traders were willing to exchange $1 of UST coins for 98 cents of bitcoin – a 2% downward deviation from the $1 peg.
While it is not new to hold assets/collateral and lend their value to justify the peg in stablecoins, it’s rather difficult to explain how an external protocol, i.e., Bitcoin, which is mostly alien to the Terra ecosystem, can help secure its value at times of distress.
The Anchor Protocol is a high yield saving account offered on the Terra stablecoin UST that currently offers an 18% APY.
Proposal 20 passed in March, which means that the interest rate will drop 1.5% per month until an equilibrium that balances the income and expenses of the protocol is reached. The first-rate drop started May 1, 2022, and each month, it will drop another 1.5%. In a later section, I show that the equilibrium rate is about 3%.
Anchor earns income through 3 primary sources: Borrowings, Collateral and 1% of liquidations. The Anchor Protocol has $13.3 billion in deposits and would need to pay out $2.5 billion in interest per year. Most of their income comes from bonded assets, but even with the borrowing rates tacked on, herein lies the problem: there would be a $1.8 billion a year deficiency at today’s rates, deposit and loan levels.
When there is a deficiency, it must pull from the yield reserve. The deposit rate will be forced to the market-clearing rate when there is no yield reserve, which we will estimate in the next section. The yield reserve has been under constant pressure since Anchor was launched because deposits have vastly outrun borrowings as investors clamour for the near 20% interest rate on a stablecoin.
Back in July 2021, TerraForm Labs injected $70,000,000 UST into it because it was at risk of running dry at the time. The yield reserve was projected to last 1.5 years, but deposit assets tripled in only a few months afterwards, which drained reserves nearly to depletion. Then Terra was forced to develop another bailout solution on Feb 18, 2022, to the tune of $470,000,000.
Thus, this somewhat suggests that Anchor’s staking mechanism, while lucrative enough, is unsustainable.
Its unsustainability was alarmed by critics and folks across Web2 and Web3 ecosystems. It'd not only led to skyrocketing deposits into the protocol and pushed the Terra ecosystem into very high-intensity growth but also led to speculations.
Role of Market Makers
UST also relies on the open market to maintain stability, requiring third-party market makers like Jump Crypto, a significant stakeholder in the Terra ecosystem, to keep it trading at the peg.
The term market maker refers to a firm or individual who actively quotes two-sided markets in a particular security, providing bids and offers (known as asks) along with the market size. Market makers provide liquidity and depth to markets and profit from the difference in the bid-ask spread.
The Downward Spiral
Then, something happened this weekend that caused many UST sales. The reason for this is still not entirely apparent.
That selling pressure caused UST to lose parity with the dollar. That’s not the first time this has happened. In May of 2021, the price of UST fell as low as $0.96 before recovering. But on Monday, the price dropped to as low as $0.61. The same day, the LFG said it would “defend” the peg by lending out $1.5 billion in bitcoin from its reserve to over-the-counter trading firms so they could support the market activity and help maintain parity with the dollar.
On the night of May 8, the Luna Foundation Guard (LFG) entered the fray. LFG announced that it would be deploying $1.5 billion of its reserves:
Loaning $750 million of BTC to market makers to be sold to defend the peg of UST
Loaning another $750 million of UST, which was to be used to buyback BTC after volatility subsided
However, despite this announcement and the initially successful peg defence, there were signs that confidence in UST was already permanently shaken. Between May 7 - May 8, Anchor saw more than $2.86 billion in outflows, with deposits falling ~20.4% from $14.02 billion to $11.16 billion over the two days. Meanwhile, the price of LUNA dropped roughly 17.1%, from $76 to $63.
The Domino Effect
The situation has also wreaked havoc through the broader crypto market, which has also sold off dramatically since May 10, falling more than 11.3% and losing more than $169 billion in value. In addition, the panic has bled over into other stablecoins, particularly Tether (USDT).
The incident also brings increased regulatory scrutiny onto crypto, particularly stablecoin issuers. Per reporting from CoinDesk, the European Commission is floating regulations that would cap the issuance of stablecoins which see more than 1 million transactions per day at €200 million. In addition, U.S. Treasury Secretary Janet Yellen mentioned UST’s collapse when discussing the need for oversight over stablecoin issuers in congressional testimony.
Lastly, we can’t deny the immense loss of capital and what it has caused for retail investors. While there is no replacement for the loss of trust and time, all we can say is to have a strong understanding of first principles before buying into an investment decision and be diligent in research before putting in any capital.
Crypto is resilient and will thrive, but it’s time for us to take a step back and rethink.
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