The Dark Side of the Moon
It has been a historic week for all of us — where we witnessed the fall of the moon (LUNA).
This isn’t the easiest to write while we witness the ongoing disillusionment and despair with what was once a bright light in the market.
Looking back throughout our time in crypto, many of us have experienced the euphoric highs, and the unbelievable wealth created. Which makes it so easy to forget that all can be lost in an instant.
We hope that this story of the moon can serve as a timely reminder to all of us: while we navigate the immense, transformative opportunity of crypto, sometimes things will fail.
And we will all get better from here.
Terra, LUNA and UST
Terra was an ambitious project and blockchain with a mission to create decentralized money, for a decentralized world.
It was centered around UST, an algorithmic stablecoin meant to match $1 of USD.
There are 3 types of stablecoins — and each maintains its peg to USD differently
- Fiat-backed: Backed 1:1 by USD or money-market instruments in reserve (USDC, Tether). Fiat-backed stablecoins are centralized, meaning they are controlled by an authority or issuer.
- Crypto-Collateralized: Backed by other crypto-currencies and is typically over-collateralized to account for market volatility (DAI). Crypto-collateralized stablecoins like DAI are decentralized, meaning they are not controlled by any issuer, but are managed by code.
- Algorithmic: As an algorithmic stablecoin, it maintains its peg via market incentives and arbitrage (UST, USDD)
Without the need to hold any capital in reserve, Algorithmic stablecoins are in theory, infinitely scalable. If they work.
The Terra blockchain’s native coin LUNA was key to UST’s stabilizing mechanism.
You can always redeem 1 UST for $1 worth of LUNA. The moment it is not $1, you can basically arbitrage and earn a profit.
For example, if UST is at 0.95, you can swap it for $1 worth of LUNA. By doing so, it burns (reduces the supply) of UST, mints (increases the supply) of LUNA, and brings the price back up to $1.
UST’s popularity
UST became popular rapidly, in particular, due to Terra’s flagship savings protocol called Anchor which offered savers a ~20% p.a return on their deposits.
So where did the 20% yield come from?
In many ways, Terra was operating like an Uber or Lyft that spent millions of dollars on incentives for you to start using them.
Enter the Luna Foundation Guard…
Luna Foundation Guard
The Luna Foundation Guard was a Singapore-based foundation created by Terra with over-arching objectives to ensure UST is pegged 1:1 with USD, and to encourage adoption of UST.
- It was launched with US$4b of LUNA reserves (at that time) in January 2022
- It acted as a treasury for UST and started accumulating Bitcoin and other assets in reserve. It was said to have about US$3.5B in Bitcoin before Terra’s downfall
- The treasury essentially funded Anchor’s almost unbelievable 20% p.a deposit rate
So how did a stablecoin become “unstable”?
- There was a major attack on UST to try and “break the peg” with USD from someone with deep pockets.
- The “attacker” removed a lot of UST liquidity from Curve, the biggest stablecoin exchange and started dumping UST on the open market.
3. This cause the first minor depeg. At this point, FUD (Fear, Uncertainty and Doubt) had spread in the market about UST not being able to keep its peg.
4. The Luna Foundation Guard started selling its Bitcoin reserve to defend the peg. This caused sell pressure on Bitcoin, and the broader market (due to its strong correlation with Bitcoin), which began to fall.
5. Mass panic followed. People started withdrawing their UST from Anchor, causing a bank run.
6. They were swapping it for LUNA and dumping LUNA on exchanges, causing a death spiral on LUNA and UST, due to the way it works as described above. Exchanges like Binance halted UST & LUNA trading.
7. Meanwhile, the attacker is still dumping UST on the market.
9. In the midst of the fallout, Do Kwon, Co-founder of Terra had promised a recovery plan.
10. While everyone was waiting for the rescue plan, word on the street was that a “bailout” was brewing. The market reacted negatively to this as it wasn’t a great deal — who would want to buy LUNA in a death spiral? It was soon confirmed that the fundraise fell apart.
11. It took more than 24 hours for a follow-up, only for Do Kwon to announce that “There is no way around it.”
12. Alas, LUNA’s price has plummeted ~100% in a week.
Key Takeaways
It is truly heartbreaking to witness the fall of a giant (Terra was once a US$40b ecosystem).
The light at the end of the tunnel is, like every crisis, we will emerge stronger and more resilient. And we are grateful we are in a position to reflect to become a better version of ourselves.
“Pain + Reflection = Progress” — Ray Dalio
1/ No ecosystem is too big to fail: Many investors believed Terra, with its huge market cap, top-tier backers, huge coffers, and celebrity founder will be too big to fail. Which ultimately led to their downfall as they were waiting for a bailout during its death spiral.
2/ The weak will not survive: Industry shake-outs such as this will weed out the weak with poor fundamentals and design flaws. This will only serve to increase our resilience.
3/ Markets are not rational: A key assumption that Terra had relied upon is that market participants are completely rational — as the design of UST relies on arbitrage to maintain its peg. What happened is validation that market participants are highly emotional and will not act rationally in fear.
4/ Uncollateralized algorithmic stablecoins have no safety net: Without collateral, nor widespread real-world use cases, pure algorithmic stablecoins lack a true backstop. And having that is critical for stability — as the word “stable” in stablecoin suggests.
5/ Regulation is a safeguard, not a mechanism to prevent: It breaks our heart to hear about wealth being wiped out, lives ruined, and even some investors contemplating suicide as a result of this episode. It makes us wonder: what if regulation was introduced to protect investors? Would the fallout be as immense? This clearly demonstrates the importance of having safeguards in place.
It is our mission is to build a secure, safe financial world that empowers everybody. And we see regulation as the true genesis of mainstream adoption.
6/ We will emerge stronger: If history will give us any indication of how our future will look like — we survived the Mt Gox Hack in 2014, the Dao Hack in 2016, and the 2020 global pandemic, crypto has emerged stronger in each cycle.
We believe the story of the moon is one about hope.
Please note none of the above is financial advice.
