The Collapse of Terra Luna

The Terra network, a $60 billion crypto empire, that was on an upward trajectory since its inception in 2018 toppled in May in just a few days, leaving many counting their losses. The unexpected fall affected many investors and the cryptocurrency field as a whole. In this piece, I will decipher how the events leading to the relapse unfolded.
In 2018, Do Kwon and Daniel Shin founded Terraform Labs in response to a failed digital currency project. The lab came forth with Luna (LUNA), which was the token to be produced from the Terra blockchain and TerraUSD (UST) stablecoin later on in 2020. The UST was a stablecoin.
A stablecoin is a cryptocurrency that serves to be a means of exchange and has its value pegged to a stable asset, like the dollar. The pegging deters the volatility that exists in other cryptocurrencies making it a reliable mostly used by traders to buy and sell riskier assets.
Unlike other stablecoins, UST is algorithmic — it does not have any physical assets or bank holdings that preserve its value but rather derive its stability from algorithms that link its value to Luna. The two, UST and LUNA, kept a balance between them in that the minting of a UST was equivalent to burning LUNA worth a dollar and vice versa. This principle sees to it that the supply and demand of the coins balance out and thus stabilize their prices.
However, as revolutionary as the algorithmic stablecoin technology sounded, it was subject to criticism from crypto experts who were skeptical about it. Among them, was Charles Cascarilla, founder of Paxos who cast his doubts about the project in his interview; Mr. Younassi, a Scalar Capital analyst, expressed his concerns over the workability of the project and predicted death spiral whereby Luna’s price crash would bring down the stablecoin with it. In all these, Do Kwon remained optimistic and proud of his achievements and shrugged his critics off.
Despite the skepticism from almost all over, funds kept flowing in to sums of more than $200 million in the period between 2018 and 2021. This by itself saw a lot of day traders hopping on the Luna train. This made the price of Luna rally from less than a dollar at the start of 2021 to highs of $119 in April 2022.
2022 is the year that saw Do Kwon announce the launch of Luna Foundation Group, (LFG) whose main agenda was to “provide a further layer of support to ensure that UST maintains its peg” if the price of UST deviates materially from the dollar peg. With Jump Crypto together with Three Arrows Capital being the lead investors, the Singapore-based firm raised $1 billion through the sale of Luna tokens and purchased Bitcoin for the UST reserve.
The year 2022, generally, began with a lot of charts being red — bearish in trend. Even though cryptocurrencies are volatile, the lows that were hit in 2022 were last seen in 2020 for some coins like Ether (ETH) and Bitcoin (BTC). This spelled doom to the cryptocurrency space as a whole and the Terra blockchain was no exception.
The collapse of Luna and its counterpart currency UST, however, was an unprecedented one. To begin with, UST was a stablecoin, one that is supposed to maintain a peg to the dollar and not have the volatility attached to the other cryptocurrencies. According to some, there was the fact of a bitcoin reserve, which to many acted as a sense of security, but, looking at it from a different perspective, the total bitcoin that was in the reserve, was not enough to offer a shield to the stablecoin in the event of a depeg.
From a different point of view, it didn’t make any sense to collateralize UST using another volatile asset, in this case, LUNA, bearing in mind the fact that the two have a positive correlation. Certain that Luna does not have collateral itself, questions on what would happen if there is a large sellout of UST emerged quite severally.
Let us look at some of the events that preceded the fall. Anchor Protocol had initially promised investors an insanely high annual percentage yield (APY) of up to 20% of their staked coins. Many made their investments in the institution leading to about 70% of the total UST in circulation being in the scheme.
However, on May 7, 2022, large withdrawals of over $2 billion worth of UST were unstaked from Anchor Protocol. Such a move is enough to disrupt its price, which it did, to the downside. Many traders went ahead to try and make purchases at the discounted price to make profits out of arbitrage which would in turn drive the prices up to bring back the parity value with the dollar.
Still, this move had a limitation as the cap of UST that could be burned for Luna in a day was set at $100 million worth of UST. This meant that the Luna token was no longer able to absorb the volume, leading to the depeg. Once the UST was unable to regain its peg, its prices dipped further as investors were quick to sell off their UST, further driving the price down.
Later on, LFG admitted to loaning out $750 million worth of BTC to trading firms as well as $750 million worth of UST that would be used to accumulate Bitcoin after the volatility is over.
When the UST completely lost its peg to the dollar, the majority of investors were quick to withdraw their funds. A move that saw the deposits in Anchor Protocol drop from $14 billion to $9 billion.
This later on in the day led to the price of UST going to lows of a fraction of a dollar. The mighty UST was reduced to mere cents.
Through all these, Do Kwon remained optimistic as he even went ahead and joked about the UST depeg on his Twitter account only later on to try and calm the community down by informing them that more funds will be deployed. This however was not to happen as the damage caused was somewhat irreversible. The depeg directly affected Luna as its price as well dropped significantly.
The two coins from the Terraform Labs enjoyed highs of about $1.09 for the UST and $119 for the Luna tokens before the depegging. The two had grown to be top cryptocurrencies that had a combined contribution of $60 billion toward the crypto ecosystem and thus its failure is one that took out a lot of investors’ wealth and lifelong investments.
The crash was an actualization of the skeptics who were not shy of their critics when the project was unveiled and still grappling to get a good footing that would set it off. Nevertheless, the crash has raised many questions varying from the enormous amount lost to the existence and functioning of the stablecoins.
That being the case, there is a lot that has its eyes fixed on the crash being a well-thought-out attack on the blockchain. The ‘who’ may not be known, but the ‘how’, I’ll explain in the next section.
Well, this is still a mystery in speculation but if it is an attack, this is most probably how it went down;
It all started on April 1, 2022, when Do Kwon tweeted the liquidity of the decentralized UST pool would be lowered from $3 billion to $350 million. This by itself jeopardized the security of the pool as it implied that the amount required to carry out an attack was now significantly less.
So, it is believed that the attacker took out a bitcoin loan and made a purchase of UST worth $1 billion. Being aware that they would only need to sell off a fraction of their UST ($350 million) to render the blockchain illiquid, they do so, making the value of UST go lower to about 99 cents where it remained for the weekend preceding the crash.
A few days later, on Monday, the value yet again dropped to 98 cents, a move that prompted the LFG to sell off their bitcoin in the reserve and purchase UST to restore the peg. If at all this was an attack, this was the one move that brought everything crumbling down as Do Kwon was now “in play” with the attackers’ books. The bitcoin selloff made the price of bitcoin drop as well as LFG was among the greatest holders of bitcoin at the time. Working on the assumption that the attackers were short on bitcoin, everything was going as planned.
Remember the $1 billion? After this move, the alleged attacker still had about $650 million left in UST. They go ahead and offload all the UST in the centralized exchanges. Panic engulfed and many people were now in a rush to sell off their UST. Mass congestion hit the blockchains which led to the suspension of transactions on the centralized exchanges, fueling the panic and eventual tanking of the cryptocurrencies. The ripple effect spread across its holders and, just like that, the peg could not be restored, plummeting the price of both UST and Luna.
As it outlined in its announcement to its users, trading of the Terraform tokens was suspended on most of the exchanges, Binance being one of them. Trading however resumed later on.
In response to the avalanche of failures that occurred, Do Kwon did not delay in stating propositions that would save the sinking Terra blockchain ship. However, one of the revival plans that garnered a lot of traction among the users and the crypto space at large was the decision to fork Luna.
After several tries to try and revive the Terra blockchain, Do Kwon decided that Terra is bigger than UST, according to his tweet. As a result, he opted to split the blockchain by using a hard fork. What happens in a hard fork is, two separate blockchains are formed, each working and existing independently of the other.
In this new plan, the original blockchain will be referred to as Terra Classic with its token going by the name Luna Classic (LUNC). The new blockchain on the other hand will be named Terra 2.0 with its corresponding token being Luna (LUNA). The new fork, now LUNA, will be different in that it will not be connected to the UST.
In a vote cast, it was clear that a majority of the Terra community was willing to go forth with Do Kwon’s proposal of forking as about 65.5% of the community agreed. The new blockchain was approved on May 25, 2022, and launched three days later on May 28, 2022.
With the plan already rolling, both the blockchain’s pre-attack and post-attack snapshots were taken to compensate for the loss. The pre-attack snapshot was taken on May 7, 2022, at block 7,544,917, and the post-attack snapshot on May 26, 2022, at block 7,790,000. These snapshots were taken as a roadmap to airdrop the 1 billion Terra 2.0 tokens (LUNA) to the holders, stakers, and app developers of the crashed tokens.
Ever since the forking and the airdrop were completed, the two tokens have maintained relatively low prices. This has however not stopped the Terra community from implementing developments that are seen to bring life back to the once-flourishing blockchain. One of them is the approval of a 1.2% tax burn of every transaction which is aimed at reducing the supply of the token while at the same time increasing demand.
Binance further announced on September 26, 2021, that it would burn the trading fees on LUNC spot and margin trading pairs by sending them to a burn address. This announcement saw the price of LUNC rally to upwards of 60%.
With the once ‘holy grail of decentralized finance’ coming down in shambles, it is crystal clear that a huge impact was felt not only on the Terra ecosystem but the crypto space at large. The confidence that had been placed in developments of its kind was as well not left behind, leaving investors much more cautious and shaky on such investments. To add to it, some were quick to lay judgment on Do Kwon terming him a fraudster.
Nevertheless, the crash has seen the Terra community grow stronger as they join hands to try and regain their lost glory. While it is at its lowest, the support it garners from major exchanges is a plus to the community as it gives a glimmer of hope that in some time to come, its value will go higher.