The Terra collapse in plain English

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Terra's collapse

In case you haven't heard yet, the stablecoin UST "de-pegged" from the US dollar this week resulting in the crash of a popular ecosystem and billions of dollars of value lost, contributing to the precipitous fall in prices we have seen in the crypto markets.

Here's UST's price chart over the last 7 days. Keep in mind that it is meant to stay at $1:

Now, we've seen tons of explainers around the internet on the UST/Luna situation that have left us scratching our heads still. And while it is a very complicated subject, we believe it's important to understand what happened because those who don't learn from the past are doomed to repeat it.

When reading and trying to understand what's happening in crypto, our measuring stick is generally "would someone who knows nothing about crypto understand this?". And most of the time the answer is no.

So, in 10 minutes or less, we'll do our best to explain what happened this past week for the crypto-curious.

We'll break it down like this:

• 🪙What are stablecoins?

• 🤔What is Terra, UST & Luna?

• 📉What the hell happened?

What are stablecoins?

We've covered this topic briefly before but we'll go into a little more depth. Stablecoins are cryptocurrencies whose prices are tied (or "pegged") directly to another currency or commodity like the US Dollar or gold.

Stablecoins exist to make crypto more viable as a means of exchange, with less volatility than most cryptocurrencies. So even though it is the same price as whatever currency or commodity it is pegged to, it still provides the benefits of crypto like decentralization and trustless transaction.

This means that transactions are truly peer-to-peer without the need for third-party financial institutions and payments can be sent anywhere in the world without the need for foreign bank accounts, just a crypto wallet.

So how do they maintain their peg to the underlying currency or commodity?

There are a few different types of stablecoins that are differentiated by the ways in which they maintain their peg. These include:

• Collateralized stablecoins - collateralized by the underlying currency which they are pegged to. These are often backed by fiat currency, but can be commodity-backed or even crypto-backed.

• Algorithmic stablecoins - controlled by an algorithm to automatically increase or decrease (or "mint" or "burn" in the crypto world) the supply of the coins based on market demand.

If you want to read more about stablecoins, Coindesk has a great explainer.

What is Terra, UST & Luna?

Founded in 2018 by Do Kwon and Daniel Shin, Terraform Labs created the Terra blockchain to be the base layer for algorithmic stablecoins.

UST is the US Dollar algorithmically pegged stablecoin on the Terra blockchain.

Luna is the Terra protocol’s native token that absorbs the price volatility of Terra. On top of that Luna is used for governance, staking, and paying transaction fees (gas) on the network.

To absorb price volatility on Terra and maintain the price peg, a USD value of Luna is always convertible at a 1:1 ratio with UST tokens.

That means if UST de-pegs (breaks from the $1 value) from the dollar, arbitrageurs can take advantage of the price discrepancies as shown below. You can see how this would become very profitable at scale:

In order to keep the price of UST pegged to $1 and keep this from happening in perpetuity, however, Terra automatically burns the amount of UST converted to Luna and vice versa. Decreased supply, increased demand - price stabilizes. Simple economics.

But with so much competition in the stablecoin market, Terra needed to drive UST adoption by providing utility beyond regular transactions. Enter Anchor Protocol.

Anchor Protocol, launched in March of 2021, is a money market between lenders and borrowers of stablecoins. The protocol offers people who deposit their UST 19.5% return annually, much higher than typical money markets. So how does it pull that off? Well, the answer is kind of complex, but here is a simplified version:

You can read more on Anchor Protocol here.

Lastly, an important part of this ecosystem mentioned in the tweet above is the Luna Foundation Guard (LFG for short). Launched in January of this year, the LFG is a non-profit, initially funded with 50 Million Luna to support the Terra ecosystem and was the main body funding the Anchor reserve. You can read more on formation of the LFG here.

In February, LFG raised $1B from venture capitalists to buy Bitcoin for the reasons below:

Now, the stablecoin UST has completely de-pegged from the dollar, sitting at about 10 cents as we write this and Luna is worth about 8/1000ths of 1 cent, down from $80 just a week ago.

But how? This begs the question...

What the hell happened?

Like we said earlier, there have been lots of explainers out there, and the missing pieces for the average joes like us have been all of the contexts above. And we don't want to take up any more of your time so we'll outline the best explainer we found from @Route2Fi on Twitter:

Here's what he says in short:

• An attacker used $350M of the $1B UST they bought over-the-counter to drain a liquidity pool on the popular decentralized exchange, Curve.

• The caused panic over illiquidity and sell-offs of UST began, with people pulling their deposits on Anchor Protocol at a rapid rate. The attacker begins selling the other $650M UST on Binance, causing further price drops. UST de-pegs to mid-90 cent range.

• LFG begins buying UST to stabilize the price, and sells the Bitcoin they bought with venture capital money to cover the costs - this leads to sell pressure on Bitcoin.

• Further panic causes de-peg to grow, people convert to Luna --> more Luna in supply ----->Luna price tanks.

• Death spiral insues (this comes from @ZeMariaMacedo on Twitter):

Now, Do Kwon has released a rescue plan for Terra, but is it too little too late?

We're unsure. People have been warning about the issues of algorithmic stablecoins and the fact that death spirals are possible for the past year+. Add in the fact that Anchor was offering almost 20% APY with funds they didn't have to sustain and many are calling this a Ponzi scheme in retrospect.

Whether history remembers it as a Ponzi scheme or Murphy's law in action, only time will tell. But one thing we hope is that lessons were learned and we are all better for it.

Glossary

We're confused too. We're here to help decrypt the crazy world of crypto.

• arbitrageurs - people or programs that simultaneously purchase and sell the same asset on different markets to take advantage of small price discrepancies.

• over-the-counter - transactions that are not conducted on regular exchanges, thus having no public order book and increased privacy. (More here.)

• liquidity pool - A liquidity pool is a crowdsourced pool of cryptocurrencies or tokens locked in a smart contract that is used to facilitate trades between the assets on a decentralized exchange (More here.)

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