Deep Dive Research
27 May 2022
Launched in February 2019, the Korea-based crypto project set out with a grand ambition: to create a stablecoin that could “power price-stable global payment systems.” This broad and grandiose goal reflected the ambitions of its young co-founder, Do Kwon. In an early Medium blog post, Kwon detailed a variegated set of utilities that Terra Luna could provide in the future, ranging from serving as a standardized token for Dapp transactions to becoming the go-to crypto asset for payroll and insurance operations.
Kwon’s vision allured many venture investors, namely Binance Labs, OKEx, Houbi Capital, and Dunamu. In the fall of 2018, Terra Luna successfully raised $32M from various VCs and made headlines on many of the top editorials covering news in crypto.
With substantial funding and a range of powerful backers, the protocol entered the limelight where it would remain at its prime over the next few years. Quickly, investors in the Cosmos blockchain ecosystem began to learn about Terra Luna, and then, in 2021, the massive bull run experienced by the entire market transformed Do Kwon’s project into a household name. $LUNA ended up trading at an all-time high (ATH) price of $116 per token - an astonishing 145-fold increase from its ICO price two years prior.
At its ATH, the Terra Luna ecosystem carried an approximate $60 billion price tag, granting it a seemingly steadfast foothold as a top-10 cryptocurrency based on market capitalization. This staggering valuation was comparable to many established, traditionally-grown enterprises around the world, like gaming giant Activision Blizzard and multinational conglomerate Softbank. Such status drove unprecedented $UST adoption around the globe, and with more than 20 billion $UST in circulation at the time, $UST became the third most popular stablecoin in the market, replacing $BUSD from crypto giant Binance.
As a purposeful stablecoin project with tens of billions of dollars in market cap, a reputation comparable to many established businesses in various sectors, and hyper-speed growth rate characteristic to the crypto industry, $UST quickly became a well-recognized name among investors. It swiftly built up a community of over 680k followers on Twitter, more than 90k members in its Telegram group, and almost 60k subreddit members. The road was paved perfectly for Do Kwon’s vision of a global, decentralized stablecoin that could facilitate quotidian transactions worldwide.
In the chaotic crypto landscape, it is essential to have an asset that can withstand the market’s volatility and retain its value. This is the role that a stablecoin plays in this wild-west industry. Stablecoins are a special crypto token whose price is “pegged” to the value of a fiat currency. The most common fiat that is utilized as a peg is the greenback US dollar, and this is also the value reference for the $UST stablecoin created by Terra Luna.
In order to stabilize $UST, Do Kwon and his team invented $LUNA, a counter token designed to absorb market volatility on behalf of $UST by means of a special balancing mechanism. In theory, any time $UST strays away from its $1 price tag, the balancing mechanism between $LUNA and $UST creates an arbitrage opportunity. As arbitrageurs take their profits, $UST’s price restabilizes at its desired price of $1.
How does the balancing mechanism work? For instance, if the price of LUNA is $10 per token then 1UST = 0.1LUNA. If the price of LUNA is $0.5 then 1 $UST = 2 LUNA. This conversion rate is guaranteed on the Lunastation. When the $UST price is less than 1 dollar, this system encourages arbitrageurs to burn $UST to mint LUNA and sell it for a profit. This subsequently reduces the supply of $UST in circulation and pushes the price upward (back to 1 dollar). The reverse trade can also be done whenever the price of $UST is greater than 1 dollar.
The value proposition of the Terra Luna project - to create a cheaper and faster global financial system - is entirely built upon the assumption that $UST can retain its 1 dollar value through the test of time and thus be trusted as reliable tender for parties within the Terra Luna ecosystem.
This fragile assumption later proved to be the fatal downfall of the project.
One name that cannot be ignored in a discussion about Terra Luna is that of its co-founder, Do Kwon. A millennial entrepreneur, Kwon graduated from Stanford University in 2015 with a Bachelor’s degree in Computer Science. After graduation, he worked as an engineer for both Apple and Microsoft before returning to his home country in South Korea to found his first startup.
Do Kwon quickly built up his influence in the crypto world, amassing almost 1 million Twitter followers, which is notably even more than Terra Luna’s official Twitter account. Many people enjoyed Do Kwon for his brusque and trenchant personality on social media, which was often visible in the arguments between him and his naysayers. It is not an understatement to say that he was not afraid to be crass and outright asinine, calling people “poor” and “cockroaches”, and even retorts like this:
The online personality portrayed by Do Kwon has certainly garnered him a diehard group of supporting “fans”, but naturally, he has attracted just as many, if not more, antagonists. It can be said that both the support and the opposition visible on Twitter fueled the fire for Kwon’s growth to fame and his confidence in Terra Luna, going so far as to challenge “billionaires” in his Twitter following to try to break his project.
The fragile foundation of the project, compounded with the provocative online presence of Do Kwon attracted many criticisms of Terra Luna, some of which focused less on Kwon’s abrasiveness and more on the sanctity of the project itself. These concerns varied from the sky-high APR on Anchor, the burning mechanism of the LUNA token, and even the fundamental architecture of the protocol.
Anchor Protocol is a DeFi platform built upon the Luna blockchain. It functions similarly to a traditional savings account provided by central banks, but with a twist. Instead of paying an annual interest rate ranging from 0.1% to 0.5% like traditional banks, Anchor paid a 20% interest rate on the $UST savings account. This APY is abnormally high, even when compared to other stablecoin staking rewards in the crypto world.
The reason for this sky-high APY appears to stem from Do Kwon’s own philosophy. In a blog post back in 2018, Do Kwon discerned that “driving adoption will be the most important challenge and differentiating factor (for stablecoins).” The 20% APY on Anchor thus served as an expensive marketing scheme to drive $UST adoption, and it certainly worked!
Billions of dollars poured into the Terra Luna ecosystem, and many used $UST as a way to enjoy favorable returns. The return was so lucrative that it at one point brought $UST to a valuation of $20 billion, surpassing Binance’s massive BUSD stablecoin.
While many investors capitalized on Terra Luna’s marketing budget, many concerned outsiders questioned the sustainability of this high yield APR, one of whom is “Algod”.
On his Twitter, the user blatantly labeled $LUNA/$UST as a Ponzi scheme, comparing it to the Bitconnect fiasco. He indicated that $UST was printed out of thin air and called the 20% rate “unsustainable”. To top it up, Algod believed that as the ecosystem grew, there would be more pressure applied on the Luna protocol.
To make his stand on $LUNA/$UST crystal clear, Algod challenged Do Kwon in a now industry-famous bet on the price of $LUNA one year later. According to the terms of this deal, if the price of LUNA fell below $80 at the same time next year, Algod would win $1 million from Do Kwon. If not, the same amount would be paid by Algod to Do Kwon.
Do Kwon portrayed the usual confidence in the Terra Luna project and accepted the terms. Furthermore, he later entered a similar bet with another Luna whistleblower, but for an amount of $10 million the second time around. These spontaneous wagers and their staggering pots became the hottest gossip for crypto enthusiasts for days on end and fueled an even hotter debate regarding the sustainability of the Luna ecosystem.
Only much later would we find that the price of $LUNA would not correlate positively to Do Kwon’s self-assuredness.
Another popular criticism of Terra Luna concerned the very architecture of the project, focusing in particular on the unsustainability of “algorithmic stablecoins” in the face of black swan-type events.
Many people compared $LUNA/$UST to $TITAN/$IRON, a similar algorithmic stablecoin project that experienced a tragic crash in June 2021. The price of $TITAN went from an ATH of more than $50 to virtually $0 within a few hours, erasing tens of millions of dollars of investors’ money in the process.
$TITAN/$IRON hada similar mechanism to $LUNA/$UST; $IRON was a stablecoin like $UST, and $TITAN was its counter token designed to absorb volatility from the market (like $LUNA). The identical structure of the two projects and the catastrophic ending of the former raised legitimate concerns about the latter.
One of the leading voices behind this argument was “FreddieRaynolds”. In his Twitter account, Freddie delineated a hypothetical attack that could bring the Terra Luna ecosystem to the ground and pointed out key structural weaknesses as well. In his words, a “wealthy attacker” can exploit vulnerabilities in the stablecoin’s architecture and pocket an enormous sum by doing so. It is the same strategy implemented by George Soros in his famous trade that brought down the Bank of England.
The tweet from Freddie was met with intense acrimony from the Luna community, eponymously named LUNAtics. The comment section of the tweet was full of incredulous LUNAtics, using language like “fudder” (people who blindly spread fears and doubts), “... a new low even for you”, or “... not being teachable.” At the height of it all, Do Kwon himself responded to the tweet,calling it the “most retarded thread I've read.” He also opted not to respond to Freddie’s specific criticisms of Luna, instead declaring that “silence is a perfectly acceptable option if stupid.”
Ironically, this “retarded” thread by Freddie was the most thorough dissertation of a plausible negative outcome for Terra Luna – a catastrophic outcome that would end up being the exact series of events that would later bring about its demise.
Every time a user wishes to swap $UST for $LUNA, or vice-versa, they would need to reserve a certain amount of $LUNA to pay gas fees. Initially, a portion of these gas fees would be distributed back to the validators as a reward for securing the network, while the rest would be “burned” and held in a designated wallet in order to maintain the value of the $LUNA token. This is a common method utilized by many blockchain protocols.
However, in October 2021, Do Kwon proposed a new “way” to repurpose LUNA’s transaction gas fees. After the approval of this proposal, the meant-to-be-burned $LUNA now instead was rerouted to a wallet under the control of Terraform Labs (TFL), the company behind Terra Luna. TFL, which is led by Do Kwon, would then use these funds to further develop the Luna ecosystem. When the proposal was passed by Luna’s community, the wallet in question held around $3 billion worth of assets. And only one person had the seed phrases necessary to access these funds – Do Kwon.
This decision raised the eyebrows of many skeptics, not only because of the inherent risk and possibility that Do Kwon could simply “disappear” one day with the enormous fund in tow but also because of the massive risk associated with centralizing a key component of a supposedly “decentralized stablecoin protocol.”
Again, alarms sounded all across Twitter following these developments. Twitter user “Jack Neiwold” published a series of tweets under the title “the LUNA exposé thread”, in which he describes in detail the “sketchy shit” that The Luna Foundation Guard was doing behind closed doors. Jack posited in his thread that the “burned LUNA” was, in fact, not being burned but redirected to Do Kwon’s private wallet. He also concluded that if the $LUNA/$UST success continued, its collapse “might destroy DeFi”.
The examples provided above are merely a sample of the skepticisms expressed toward the Terra Luna project. Among these skeptics include the co-founder of MakerDAO Rune Christensen, David Hoffman and Ben Glove from Bankless, Jordi Alexander from Celini Capital, mhonkasalo from Parafi, and OxHamZ.
Regardless of the credibility or trustworthiness of these personalities in the crypto community, all were bombarded with a firestorm of aggression and belligerence by LUNAtics on Twitter whenever they publicly questioned the validity and sanctity of the Terra Luna ecosystem. Their responses, often blatant derision with a nearly intentional omission of intellect, were reminiscent of Do Kwon’s preferred method of retaliation online; a new culture of LUNAcy had really cemented itself in the industry.
The true collapse – in the literal sense – of Terra Luna started on a popular automated market maker (AMM) platform for stablecoins known as Curve Finance. This platform was where all stablecoin projects held the bulk of their liquidity.
On this day, Curve Finance registered a huge $UST sell-off in the primary UST liquidity pool “UST-3 pool.” The sell-off began with a massive $85M $UST sell order, followed by a series of $UST swaps from $300k to $3 million. Soon, the attacker had wiped almost $300 million in liquidity from $UST and shrank the size of the pool from approximately $1.2 billion to less than $800 million in a single day. The first attack was successfully fended off by a single wallet, which swiftly sold an approximate 50,000 ETH in order to replenish the UST-3 pool with hundreds of millions of dollars in liquidity.
While the attack slightly swayed the price of $UST in Curve Finance, the stablecoin was still “pegged” at $1.
$LUNA price: $79.83
$UST price: $1
The next day, on May 8th, the attack continued. Countless $UST sell orders were queued up in Curve Finance, valued at around $300,000 a pop. In response, another wallet quickly jumped in to defend the pool with a single $250 million transfer. However, the liquidity was subsequently drowned out by the increasing number of sell orders.
By the end of the day, there only remained $274.5 million in liquidity for $542.6 million worth of $UST. The next day, that number shot to $699.4 million of $UST with merely $51 million available in counter assets.
At this point, a number $UST holders began to realize that their supposedly stable holding could be in great danger and that there might not be enough liquidity for everyone to exit safely.
The balancing mechanism of Terra Luna was created for this very scenario. Since 1 $UST can be converted to $1 worth of LUNA, many investors started to convert all their $UST to $LUNA and sell it on the open market. With no other recourse, this path seemed to be the most rational way investors could save their crumbling $UST portfolios.
Unfortunately, this caused a ripple effect, as a large amount of newly minted $LUNA resulted in the hyperinflation of the token’s circulating supply. This put enormous downward pressure on the price of $LUNA, resulting in a tumbling decline from $80 per token to a mere $60 in a matter of days.
$LUNA price: $60
$UST price: $0.99
In order to understand this part of the story, we have to pay a visit to the Anchor protocol. Offering a lucrative 20% APY, many investors were eager to glean as much as possible from the protocol. One of the ways they did this was by leveraging their staking position on Anchor. By doing so, investors could make as much as 160% APY on their initial capital, eight times as much as the offered yield.
The risk, however, associated with leveraging on the protocol is that investors’ positions are highly sensitive to $LUNA’s price fluctuation. Thus, as the price of $LUNA began to fall, many investors borrowed $LUNA/bLUNA, which were liquidated and sold on the open market. This created a cascading effect for the price of $LUNA. As its price dropped, more $LUNA would be sold on the market, causing the price to plunge even further.
This positive feedback loop deteriorated $LUNA’s price throughout the 9th of May, causing it to stray away from $60, a psychologically significant, round number value. It is believed that, at this point, many retail investors had yet to grasp the gravity of the situation, since $UST was still trading at around 99 cents. On the flip side, a number of whales had caught on to the alarming situation and were trying to cash out at their position as quickly as possible, causing the UST-3 pool on Curve Finance to drain even more.
$LUNA price: $57.5
$UST price: $0.98
Initially, $LUNA had a $40 billion market value that was used to insure around $18 billion of $UST. This was a safe position for the Terra Luna ecosystem, as the large market valuation of $LUNA indicated that there was an abundance of assets prepared to back up the valuation of $UST. However, after days of price contractions, on the 10th of May, for the first time ever, the total value of LUNA in circulation was less than that of $UST.
This was it. This was the breaking point at which any remaining dwindling trust in the system disappeared completely. With all holders of $UST utterly convinced that their stablecoin was now anything but stable, $UST was being sold at every available DEX and CEX in the crypto landscape. The overwhelming sell pressure on $UST rendered its price to a low of 78 cents while LUNA’s price also fell freely to a low of $26, losing more than half of its valuation from yesterday.
In a last-ditch effort, LFG came into play, selling the remaining 33,000 $BTC in their bitcoin reserve for$UST, hoping to save its price with a blunt 1.1 billion $UST buy order. However, the bold move was simply too little too late. Even with a slight recovery, the price of $UST never returned to its $1 peg.
Since its inception, the Terra Luna foundation revolved around the stability of its $UST stablecoin. The moment investors realized that $UST would not be delivering on its promise was the moment the entire protocol had no choice but to surrender to its disastrous ending.
$LUNA price: $30
$UST price: $0.8
The final $BTC sell order from the previous day brought the whole cryptocurrency market down, and it still could not save $LUNA. $30 dollars per LUNA quickly became $15 per LUNA, then $10, then $5. $LUNA’s price declined asymptotically to zero.
Compared to its prime-time market value of more than $40 billion, all the $LUNA in circulation was worth as low as $43 million on the 12th of May, equating to a 99.9% loss for investors in a few short weeks. Tens of billions of dollars evaporated. VCs, retail investors, and virtually everyone in the ecosystem suffered an enormous loss.
A loss of this caliber, while rare, is not unheard of in cryptocurrency. What makes this epoch stand out is the sheer magnitude of the project itself, and the pain it wreaked on everyone who trusted it.
The loss did not only affect those veteran investors with a high-risk tolerance seeking abnormal returns; it wiped out many average people’s life savings that relied on the stability of $UST. These people trusted the protocol and delegated their hard-earned money to grow their wealth not through a gamble, but an investment. These people did not seek profits; they sought shelter.
It is one thing to advertise a high-risk, high-return investment product to knowledgeable, prospective investors. It is an entirely different thing to convince non-speculative clients to put their money into a “savings account” that is anything but safe.
At the time of writing:
$LUNA price: $0.00019
$UST price: $0.08
After the collapse of Terra Luna, algorithmic stablecoin projects are again under heavy scrutiny by investors and regulators, who hope to reassess their worth. Having wiped $50 billion in market valuation off the face of the planet, Terra Luna certainly grants credence and cogency to the skeptics, and for good reason. Embedded within the architecture of algorithmic stablecoins is the perfect setup for a death-spiral event – one that can knock the stable token off its peg and drive its value to the ground. Given the robust socioeconomic environment globally, these events are bound to happen at some point in time.
On top of that, an unsustainable 20% yield naturally attracts speculators into the ecosystem. In fact, more than 70% of $UST in circulation was locked up on Anchor to farm that lucrative yield. So, instead of existing as a medium of exchange in the crypto landscape, $UST was really more of a farming tool to reap risky rewards from Anchor.
By nature, speculators do not inject trust that strengthens the ecosystem. Rather, they speculate – they remain when money comes in and are the first ones out the door during a market shakeout. When $UST lost its peg, we saw just this; an enormous amount of speculative investments were frantically removed from the protocol, causing irreparable damage to the fewer genuine supporters of the project.
Algorithmic stablecoins are an attractive and lucrative concept that may allure more entrepreneurs and investors in the future. However, they should remember two important takeaways from the downfall of Terra Luna: (1) an ecosystem that can provide organic utilities for the stablecoin is essential, and (2) a stablecoin is worth virtually nothing without the trust of its community.