The inside story of terra luna's collapse

The inside story of terra luna's collapse

it's time to find out  what really caused terra to implode  let's take it from the top so that we're  all on the same page  terra was and i suppose technically  still is a crypto project founded in  early 2018 by ivy league educated  economist daniel shin an ivy league  educated computer scientist doe Quan  terra was built by terraform labs or tfl  a South Korean software company which  was incubated by the terra alliance a  group of 15 Asian e-commerce giants  note that terraform labs is based in  Singapore  do Kwan has served as the CEO of  terraform labs since its inception and  daniel shin left terraform labs in early  2020 to become the CEO of the chai  corporation a payments app that  leverages terra,  terra's development is coordinated by  the luna foundation guard or lfg a  Singaporean non-profit that was  incorporated in January this year  note that all these details will be  relevant later so listen close  the luna foundation guards governing  council consists of seven individuals  including do Kwan as well as  representatives from prominent crypto  VCs like jump crypto and Delphi digital  and even finance labs . 

 now terra raised roughly 47 million dollars across three icos in 2018 and has since raised tens of millions more from prominent crypto VCs namely galaxy digital which invested 25 million dollars in terrain in early 2021.  terra's main net went live in April 2019  and its blockchain was built using the cosmos in   SDK  this means tera can process thousands of transactions per second while remaining secure though it is quite centralized with just 130 validators note that terra's validators are also the price oracles for terra now terra is or rather was an ecosystem of decentralized stable coins and its purpose was to power the next generation of payments with its various decentralized digital currencies and the various decentralized applications that were being built on the terra blockchain luna is terra's native cryptocurrency coin and it's used for staking on the terra blockchain to pay for transaction fees on the terra blockchain and to table and vote on governance proposals for the terra blockchain luna is also used to ensure there are various decentralized stablecoins remain pegged to their respective fiat currencies.

  now it does this using a novel mint and  burn mechanism plus free market  arbitrage  ust was or rather is terra's largest  decentralized stablecoin and it is or  rather was pegged to the us dollar  like everyone else I'll use us to  explain exactly how terra's mint and  burn mechanism works don't worry I'll  keep it super simple  on terra one dollars worth of luna can  always be burned to mint one ust and one  ust can always be burned to mint one  dollars worth of luna  now suppose ust is trading at 1.50 or 50  percent above its one dollar peg  if you hold luna you could burn one  dollars worth of luna to mint one and a  half ust and then sell that newly minted  just for say another stablecoin  the result is an instant 50 profit and  the increase in use supply combined with  the cell pressure from you and other  lunar holders who are minting and  selling ust eventually brings us back  down to its one dollar peg  obviously the prospect of these instant  profits creates buying pressure for luna  as well  logically.

 the same process applies in  the other direction for example if ust  is trading at just 50 cents or 50  percent below its peg as a ust holder  you could burn one ust and essentially  mint twice the dollar amount in luna and  make a 2x profit assuming you  immediately sell that luna for something  else  this reduction in usd's supply combined  with the buying pressure for ust from  traders who want to make a quick profit  eventually brings ust's peg back up to  one dollar  now this is why ust is referred to as an  algorithmic stablecoin and though this  process of maintaining a peg sounds  robust on paper in practice a de-pegging  of ust to the downside runs the risk of  something called a death spiral  as i just mentioned when ust drops below  its peg there's a huge incentive for  traders to come in and buy that ust burn  it to mint luna and sell that luna for  an instant profit i'll repeat that in  order to realize this profit that newly  minted luna must be immediately sold  now when the crypto market is on the  rise this process isn't necessarily a  problem because there's lots of  speculative demand for luna and that  means any selling by ust arbitrage  traders is unlikely to affect its price  if at all  when the crypto market is on the decline.

  however, this process does become a  problem because there's not much speculative demand for luna and that means its price is going down while it's being aggressively sold by ust holders this makes its price fall even further and causes panic among ust holders and this is the short explanation of what happened to terra as you will soon see however there were a lot more moving parts beneath the surface and the first part we need to examine is something called seigniorage on terra minting just by burning luna costs a small fee in luna called for a long time seniority fee went to terra's community treasury after a while the size of terrace  community treasury had grown so large that  the terra community voted to burn all seniority fees as part of the Columbus 5 upgrade last September the terra community subsequently voted to convert the 89 million luna in the treasury to mint around 4.5 billion just in November 

so yes it was large to say  the least  in the months that followed the terra  community approved various proposals to  bridge ust to just about every major  smart contract cryptocurrency as part of  the project's mission to make ust the  most accessible stable coin in the  crypto markets  when ust bridged to other blockchains  some kind of liquidity mining rewards  were almost always involved  put differently anyone who used ust in  d5 protocols on other cryptocurrency  blockchains would earn additional  cryptocurrency be it luna ust or some  other coin or token  naturally these additional rewards  created a lot of demand for ust  this increased demand for ust would push  it ever so slightly above its one dollar  peg and ust being above its peg would  incentivize market participants to buy  and burn luna to mint ust for a small  profit this not only caused ust's market  cap to increase exponentially but it  also caused luna's price to increase  exponentially  that's because of basic economics luna's  supply was gradually being reduced as  people burned luna to mint ust for a  small profit  with demand for luna simultaneously  increasing while the number of lunar in  circulation fell this caused its price  to rise rapidly  this dynamic is why some claim that  terra is a ponzi.

 but if we're being  honest a similar dynamic exists with  just about every other asset on the  planet for that matter heck even stocks  only continue to rise because of  increasing demand over time  i digress  at its peak in early april luna hit a  high of 120 dollars and tera surpassed  solana to become the sixth largest  cryptocurrency by market cap  meanwhile ust's market cap and  circulating supply was just shy of 19  billion making it the third largest  stablecoin after tethers usdt and  circles usdc  ust was also listed on all of the most  reputable crypto exchanges including  coinbase binance ftx and kucoin with  many crypto and ust trading pairs so not  just with other stable coins  although lots of demand for ust was  coming from all of the d5 protocols  offering liquidity rewards the  overwhelming majority of demand for ust  was coming from a single d5 protocol on  the terra blockchain called the anchor  protocol which held almost 80 percent of  all the ust in circulation  this brings me to the second moving part  beneath the surface which is of course  anchor protocol  as many of you will know anchor protocol  was famous for offering a stable  interest rate of 20 percent per year on  ust  this suspiciously high rate led many  people to accuse anchor protocol of  being a ponzi but this also doesn't seem  to be the case when you consider how  exactly anchor protocol works.

 i'll  use a simple analogy to explain  imagine there's a bank that's offering a  five percent annual interest rate on  savings the good old days if you will  now let's say some rich bloke comes  along and deposits 100 billion dollars  into this bank  quick maths tells you that this rich  fellow will rake in five billion dollars  per year from his massive cash pile  now let's say that some poor bloke comes  along and deposits 100 into the same  bank quick maths tells you that this  poor fellow will make just five dollars  per year from his tiny cash pile but the  bank has a special deal for him  for a limited time we will give you an  annual interest rate of 20  how is the bank going to give this poor  bloke this interest rate you ask easy  just take 20 from the 5 billion of  interest coming from the rich blokes  massive cash pile and add it to the poor  bloke's tiny cash pile billy big bags  won't even notice  now jokes aside because the interest  being earned by the rich blokes cash  pile is so massive the bank can afford  to give a 20 interest rate to literally  thousands if not hundreds of thousands  of poor blokes and potentially secure  thousands.

 if not hundreds of thousands  of new customers  there's only one thing the bank must do  and that's to convince the rich bloke to  let it redirect the five billion dollars  of annual interest on his massive cash  pile to all the small cash piles of the  poor blokes  how is the bank going to convince the  rich bloke to give up his annual  interest you may ask easy  just offer him shares in the bank itself  that will give him control of how the  bank operates and promise to use a  portion of all the interest being  generated by the bank to purchase more  shares so their prices stay high  now believe it or not but this is almost  exactly how anchor protocol works or  rather worked on anchor protocol the  rich folk would deposit large amounts of  staked luna from terra staked atom from  cosmos staked soul from solana staked  avax from avalanche and even staked eth  from ethereum  the annual staking rewards for these  proof-of-stake cryptocurrencies was or  rather is 5 or more all these staking  rewards from the rich folks would get  converted into ust by the anchor  protocol and then this ust would be  given to the poor folks who were  depositing ust to earn 20 per year.

  if the staking rewards being earned by  all proof-of-stake cryptocurrencies  provided by the rich folks exceeded the  amount needed to provide poor folks with  a 20 yield on ust these additional  staking rewards would again be converted  into ust and deposited into the anchor  protocol's yield reserves which would be  used to keep paying the poor folks when  there aren't enough rich folks around  in return for providing proof of stake  cryptocurrencies the rich folks would  get anchor protocols anc token which is  used for governance and a portion of  anchor protocol's yield reserves would  be used to buy and to ensure that its  price increased along with the  popularity of the protocol as with  terra  itself anchor protocol worked  much better on paper than it did in  practice because in practice there are  many more poor folks than there are rich  folks  in other words the staking rewards  coming from the proof-of-stake  cryptocurrencies provided by the rich  folks was not nearly enough to continue  paying a 20 interest rate on ust for all  the poor folks .

 as a result the yield  reserves were being drained rather than  filled  now to be fair this is something that  the anchor protocol team and community  were aware of and it's why they were in  the process of reducing the protocol's  20 interest rate to something more  sustainable  in the interim anchor protocol's yield  reserves were being replenished with ust  coming from the entities behind terra  and this ties into the third moving part  beneath the surface the lunar foundation  guard  as i mentioned earlier the luna  foundation guard or lfg is the  singaporean non-profit that coordinates  terra's development however the lfg  plays another more important role and  that's to ensure ust's peg remains  stable at all costs as many of you will  know the lfg is famous for buying up  billions of dollars of btc which was  going to be used to protect ust's peg  what many of you might not know is the  back story to how this btc treasury came  to be  prior to the events of last week ust  held its peg quite well save for three  occasions  the first was at the end of december  2020 when ust fell sharply below its peg  for about a day.

  now i actually couldn't find the exact  cause of this but if you know please  drop a comment below  anyways the second time ust lost its peg  was during the crypto crash last may  when ust fell significantly below its  peg for more than a week  in an interview from last october terra  co-founder do kwan explained that it was  last may's crash that really made the  terra team start to think about how  they could protect ust's peg and they  settled on btc as the ideal backing for  ust during times of volatility  however it was ust's third major  de-pegging event that really kicked the  terra team in the keister and that was  when ust fell slightly below its peg in  january  now this d-pegging was reportedly caused  by a d5 protocol called abracadabra  which makes it possible to mint another  decentralized stablecoin called magic  internet money or mim using  interest-bearing tokens as collateral as  you might have guessed ust was one of  the tokens that could be deposited into  abracadabra to mint mim specifically a  ust which is an interest bearing token  given to ust holders as a sort of  receipt for their ust . 

when they deposit said ust into the anchor protocol on abracadabra some d5 degens came up with a clever strategy called the degen box which is where you deposit aust into abracadabra to mint mim then use the mim to buy ust deposit us into anchor protocol to get more aust deposit that must into abracadabra and so on until you have lots of yields now it doesn't take a d5 expert to realize that this defy strategy is extremely risky because if mim or aust deviates from its peg by even just a  couple of percentage points the entire scheme could collapse very quickly and in terra's case this had the potential to do serious damage to us and luna as it so happens it was discovered that one of the people working closely with the developer behind abracadabra was the co-founder of quadriga cx the infamous Canadian cryptocurrency exchange which collapsed after its other co-founder died while on holiday in  India.

 so the story goes  this shocking revelation spooked holders  of the coins and tokens associated with  abracadabra and this is ultimately what  caused us to fall slightly below its  one dollar peg  realizing the exponential risks  associated with having just one so many  chains and in so many d5 protocols the  recently incorporated lfg moved forward  with the plan to use BTC to protect  UST's peg  this relates to the fourth moving part  beneath the surface the lfg's BTC  accumulation  about a month after the LFG was  established it started raising the  capital required to purchase boatloads  of BTC starting with a one billion  dollar raise from prominent crypto VCs  including jump crypto and three arrows  capital which was financed through  over-the-counter sales of life's lunar  holdings  the plan was straightforward buy up  enough BTC to back 20 percent of UST's  circulating supply and then use there's  aforementioned senior ridge fees to  automatically purchase additional BTC  every time someone burns luna to mint  must  recall that seniority fees are currently  burned .

 now given UST's circulating supply at  the time backing 20 of it with BTC would  require just over 3 billion worth of BTC  with only 1 billion raised and much of  it spent the LFG needed some additional  capital to continue its BTC accumulation  in early march terra co-founder do Kwan  announced that terraform labs had gifted  1.2 billion dollars worth of luna to the  LFG which would be converting it to us  and using said ust to continue buying  BTC  a few days later doe also announced that  terra was aiming to accumulate 10  billion of BTC to protect UST's peg with  3 billion being accumulated by the LFG  and the remaining seven billion being  accumulated overtime via seniority fees  shortly after that jump crypto posted a  plan for how exactly BTC could be used  to protect UST's peg to terra's  governance forum and the short  explanation is that the LFG would  deposit all its BTC into a non-custodial  reserve pool where anyone could redeem  us for BTC the same way they do with  luna  the assumption .

there is that if ust were  to drop significantly below its peg  rational market participants would opt  to swap their one just for one dollars  worth of BTC rather than one dollars  worth of luna  this would take the cell pressure off  luna and prevent the death spiral  scenario i was talking about earlier  jump crypto's plan was actually  extremely detailed I'll leave it in the  description if you're interested  anyhow in early April Binance added  support for the anchor protocol making  it possible for its 30 million users to  earn high stable yields on just  note that I'm just mentioning this to  underscore just how integrated terra was  with the entire crypto ecosystem  terraform labs and the luna foundation  guard also purchased 200 million dollars  worth of avalanches avacs as part of an  ongoing plan to add other  cryptocurrencies to terra's stability  reserves for ust  down had earlier mentioned that their  plan was to eventually start  accumulating the cryptocurrencies that  belong to the smart contract blockchains .

 ust is available again this will all be relevant in just a moment in mid-April terraform labs gifted yet another 900 million dollars worth of luna to the LFG to sell for more BTC  all the while the LFG was giving frequent updates about its BTC buys which would happen in waves of around  100 million dollars at a time the lfgLFG also made all its crypto wallet addresses public for everyone to see the accumulation in real-time the LFG achieved its target of backing  20 of USD circulating supply on Thursday may the 5th with a 1.5 billion BTC buy financed through the sale of luna to three arrows capital and genesis global trading a crypto otc broker and a subsidiary of digital currency group and then everything went to s-h-i-t terra's implosion arguably began on Saturday the 7th of May and I'll quickly note that the following order of events has been confirmed to one of the researchers here by a  high profile member of the terra community who shall not be named.

 i'll also highlight events where  speculation is involved  on Saturday night the terra team  withdrew a massive amount of dust from a  trading pool on curve finance  for context curve finance is a  decentralized exchange for stablecoins  and the terra team withdrew all that  ust in preparation for something called  the four pool which i won't get into  here all you need to know is that the  moment the terra team withdrew this ust  an unknown whale sold around 85 million  ust for 85 million USDjus on curve finance  and this pushtust slightly below its  peg  there is speculation that another 200  million dollars of ust was  simultaneously sold on Binance and  though lots of well-respected folks in  the crypto space swear that this  happened it cannot be confirmed  regardless of where the cell pressure  was coming from it was enough to push  us slightly below its peg  now because the crypto market had  already been crashing in the days prior  risk-averse individuals and institutions  with exposure to dust immediately started  selling out of safety concerns.

 this  isn't speculation  in a recent interview with digital asset  news celsius ceo alex mizinski said they  pulled all their and their users assets  out of the anchor protocol as soon as  ust fell slightly below its peg and this  was almost certainly the case with  similar crypto apps that had exposure to  ust and the anchor protocol  as you can see around 9 billion of the  14 billion ust on anchor protocol was  withdrawn within the first 48 hours of  ust falling slightly below its peg  this mass exodus from the anchor  protocol created intense cell pressure  for ust as everyone exchanged it for  other stablecoins and this pushed ust  significantly below its peg  when that happened various market  participants started burning ust to mint  luna for a quick profit which of course  requires selling luna right away to  realize especially since luna's price  had already been crashing along with the  rest of the crypto market  this cell pressure on luna as well as  the sudden increase in its circulating  supply crashed its price even further  and the moment luna's market cap fell  below ust's market cap luna officially  entered the death spiral with more luna  being minted while its price was reduced  to ashes  this is simply because ust is  fundamentally a representation of the  potential cell pressure on luna .

 it  appears that many lunar and ust holders  took this realization to heart if ust's  market cap is larger than lunars then it  can't absorb the cell pressure from ust  and that means it's going to zero  with luna's price in freefall the  integrity of the terra blockchain  itself was under threat as an attacker  could manipulate the governance  proposals that people were trying to  pass to stop the bleeding  a low lunar price also made it easy for  a malicious actor to become a validator  and manipulate transactions  left with no other option tera's  validators agreed to halt the chain for  a while to try and buy some time  upon restarting the chain the chaos  continued so terra's validators halted  the chain again before restarting it for  a second time but with terra's mint and  burn mechanism for stable coins disabled  all the while terra's luna foundation  guard was aggressively selling btc on  the spot market with the help of  multiple market makers on multiple  exchanges and the lfg revealed in a  recent twitter thread that it had  basically emptied the clip it spent over  80 000 btc to try and restore ust's peg  on-chain analysis done by glass node and  elliptic seems to confirm the lfg's  claims.

 now there is speculation that the same  entity that dumped ust on curve finance  and supposedly on binance also opened a  short position on btc knowing that the  lfg would be dumping its btc on the open  market thereby crashing btc's price  there are again many prominent crypto  personalities who insist that this is  what happened and some have even gone as  far as to say that the attacker even  used the profits from shorting btc to  continue attacking terra through its  mint and burn mechanism now  unfortunately none of this can be  confirmed  by friday the 13th of may both luna and  ust had flatlined dealing a 40 billion  blow to luna and ust holders and tens of  billions of more dollars in damage to  the individuals institutions d5  protocols and smart contract  cryptocurrencies that had exposure to  terra's ecosystem which was almost all  of them  and yes one of those individuals was me  so who is to blame for tara's collapse  well i'll start by saying that nobody  currently knows who's behind it all and  maybe we'll never know  all we have right now is speculation  based on what are likely just  coincidences but all signs seem to point  to wall street and here's why  almost every single individual and  institution in cryptocurrency had  exposure to terra.

 in some way shape or  form  vcs were heavily and i mean heavily  invested in this project and they  genuinely believed in its potential like  so many of us did and some still do as a  quick side note i remember at the coin  bureau conference a couple of weeks ago  we asked the crowd how many people were  using anchor protocol and almost  everyone raised their hand literally  hundreds of people  it's just one of many examples of how  widespread the adoption of terra really  was  if you accept this premise the only  place this potential perpetrator could  have come from is traditional finance  because i don't imagine anyone involved  in crypto would shoot themselves much  less their crypto partners and clients  in the foot by killing terra  just to  make a few billion bucks  i also don't imagine anyone involved in  crypto would want to draw the attention  of regulators by destroying a  decentralized stablecoin as far as i  know the only people who want aggressive  crypto regulation work in or work  closely with entities in traditional  finance  this is where the coincidences come in  and the first one is that the federal  reserve mentioned the risks of  stablecoin runs in its financial  stability report which was released on  the monday after terra began collapsing .

 if you ask me this really was just a  coincidence  the second coincidence is much harder to  explain away however and that's that  treasury secretary janet yellen  mentioned terra's collapse in her  testimony to u.s politicians on the  wednesday  now i find it hard to believe that word  of tara's d-pegging had reached her so  quickly unless someone she knew was  following terra's dynamics closely but  still probably just another coincidence  the third coincidence is more like  circumstantial evidence and that's the  fact that tethers usdt stablecoin also  briefly fell below its peg and that this  is something janet also mentioned in her  testimony on the thursday  this can be easily explained away by the  fears that the regulatory crackdown on  stable coins will likely affect tether  as it operates outside of the united  states and hasn't exactly been all that  transparent about the reserves backing  usdt  for what it's worth tether has  reportedly redeemed over 9 billion usdt  over the last week or so with no issues  interestingly the market cap of circles  usdc increased by about 4 billion over  the same period and busds by 2 billion a  flight to safety.

 I suppose the fourth coincidence is closer to concrete evidence and that's the timing of this supposed attack the fact that someone knew exactly when the terra team would be pulling us out of curve finance seems to be the strongest evidence that this was an attack from someone somewhere as this information was not publicly known the events that unfolded afterward could have been nothing more than various market participants taking advantage of terra's downfall be they from wall street or main street still there's no denying that this dented the crypto industry and the legacy financial system especially us dollar itself can and likely will do everything within its power to ensure  that                                                                                                                                                               it's not replaced by crypto or anything else consider for a moment that terra was building a decentralized stable coin backed by digital gold that might just be the greatest middle finger to the financial system.

 anyone can raise  now to wrap things up i want to talk a  bit about terra's future which is  currently uncertain the latest news is  that terra is probably going to fork  with the old terra  chain being known as  terra classic and the new terar chain  retaining the original name but with no  algorithmic stable coins  terra co-founder do kwan is behind this  recovery plan and he noted on twitter  that a snapshot of terra's current  blockchain will be taken next friday the  27th of may and those with luna and ust  in their wallet at that time will  receive a portion of luna's new supply  if i understand correctly the initial  supply of new luna will be the same as  the initial supply of old luna which is  1 billion and it will be distributed as  follows  25 to the community pool  35 to holders of luna prior to terrace  collapse  10 to the holders of aust prior to  terra,s collapse and you'll recall  aust is the token receipt you get when  you deposit ust into the anchor protocol  10 to holders of luna after terra's  collapse  and 20 to ust holders after terra's  collapse.