Luna Eclipsed: Behind the Collapse of Algorithmic Stablecoin TerraUSD

Over the course of a few days last week, we witnessed what was arguably the most dramatic eruption in the history of cryptocurrencies.

Just a few weeks earlier, Terraform Labs, makers of the TerraUSD and Luna cryptocurrencies, were sitting high.

Luna was valued at US$86 per token on May 5 – below its peak of US$120, but most of the tokens had fallen at the time – and it was ranked number 6 in terms of market cap among cryptocurrencies, with a total market cap of $28 billion.

On May 16, Luna was valued at $0.00022 with a market cap of $1.5 billion.

In fact, on May 13, the blockchain was shut down by the validators — those responsible for verifying the transactions on the blockchain — though it would later resume block production with some features disabled.

Terraform Labs, a VC darling backed by the likes of Pantera Capital and Kinetic Capital, saw its first initial coin offering in 2019 but really started to take shape in January 2021 after a round of venture capital funding.

TerraForm Labs founder Kwan Do-hyung (better known as Do Kwan) claimed that he had created something unique that could withstand both bear and bull markets.

Investors – retail and institutional – agreed. Luna exploded from a market cap of $2.5 billion in June 2021 to a peak of more than $40 billion in April this year.

Then, over the course of two days from May 9-11, everything fell apart.

An algorithmic stablecoin

To understand how this happened, you need to understand a bit about how stablecoins work, and how Terra/Luna worked in particular.

A stablecoin is a currency that is pegged to the value of an asset – usually the US dollar, but it can also be euros or gold.

Even though it is traded on an exchange, a stablecoin should always be valued 1:1 with the underlying peg.

There is a relatively complex taxonomy of stablecoin types, but generally they can be divided into two types: supported and algorithmic.

The three most popular stablecoins in the world – Tether (USDT), USD Coin (USDC) and Binance USD (BUSD) – are all supported stablecoins.

That means there is a central company that maintains a reserve equal to the number of tokens in circulation. In theory, Tether has $1 in real-world assets for every USDT.

The companies then guarantee that they will trade 1:1 for the asset so that you can trade 1 UDST for 1 US dollar at any time.

Natural arbitration will do the rest.

So let’s say USDT has fallen to US95c. An arbitrageur (or rather an automated bot owned by one) can and would then buy as many as they can because they can trade it immediately with Tether for $1. An instant, risk-free profit for the arbitrageur and an increase in the demand that will push the price up again.

Similarly, if the value of USDT were to go above the peg, say US$1.05, an arbitrageur bot could go to Tether and say, “Here is an amount of US dollars; please coin me an equal number of new USDT.

They would immediately sell this new USDT for a profit: that is, buy for $1 and sell for $1.05. The increase in supply would of course bring the price down again.

Algorithmic stablecoins (also called algos, not to be confused with the cryptocurrency Algorand), however, work a little differently.

They maintain a link by using supply and demand manipulation managed by (as the name suggests) an algorithm.

If the value of an algo stablecoin falls below the peg, they reduce the stablecoin’s supply to drive the price up. If it goes above the peg, they will automatically store new stablecoin tokens to increase the supply and lower the price.

Enter TerraUSD (UST), an algorithmic stablecoin with a unique price management mechanism.

Although TerraUSD was a stablecoin, it was inextricably linked to Luna (LUNA), a free-floating cryptocurrency, and the two worked together to maintain the peg.

Luna, a free-floating smart contract platform, is priced whatever the market decides (US$120 at its peak; now US$0.0022), just like most cryptocurrencies.

The key to the Terra/Luna system was that UST was, in a sense, ‘supported’ by LUNA. LUNA serves as a kind of counterbalance to keep UST going.

The way it worked was that if UST slipped under the pin, the blockchain algorithm would mint new LUNA tokens and use that LUNA to buy UST at the current exchange rate (sellers would be incentivized by arbitrage, just like in a backed up coin, to make the trade).

The purchased UST would then be ‘burned’ (ie destroyed). That would drive up demand and reduce UST’s supply to bring the price back up to par.

Conversely, if UST went above the peg, it would mint new UST and use it to buy LUNA tokens. That LUNA would then be burned. The increase in UST supply would drive the price down.

So you have a ying and yang system: LUNA is burned to beat UST when needed to keep the pen, and UST is burned to beat LUNA when needed.

Terra/Luna had numerous critics who noted that this entire system was built on sand and that Terra and Luna’s strange ouroboros could easily collapse.

But for a while the system worked, until suddenly it stopped working.

The fall

For many investors, Terra/Luna looked like a win-win situation.

Luna, the free-floating currency, only seemed to be able to move up.

During a bull market, all currencies went up, so then it would appreciate in value.

During a bear market, investors tend to pull back to stablecoins (as they don’t fall in value), meaning more UST would buy. As noted above, when new UST is created, LUNA is burned equally, so in theory the value of LUNA will still go up as supply decreases.

Unfortunately for those investors, they hadn’t anticipated the May downturn when demand for both LUNA and UST fell sharply, creating an irreversible death spiral for both currencies.

This was compounded by a change in policy from Anchor Protocol, a type of savings account for UST that had offered 20% returns and was a major incentive for people to hold UST. Up to 75% of users have deployed their UST in Anchor Protocol, according to Coindesk

Anchor Protocol announced in March that this would become a variable fare and people started running for the exits. One of the largest was crypto lending company Celsius, which had half a billion dollars worth of Anchor Protocol that it was withdrawing.

There was a major pullback from UST on May 9 (it is not clear whether this was coordinated or coincidental) that caused the stablecoin to fall under its pen. In just a few hours it dropped to US76c.

So the algorithm did what it was designed to do: it applied more LUNA to buy UST and jack up the price.

The problem was that no one wanted to buy that newly minted LUNA. The market was in bad shape and nobody bought anything.

The algorithm had to sell cheaply and print more and more LUNA to make up for the difference.

Investors, of course, took note: they saw the de-peg, and they saw the sharp drop in LUNA’s value as new LUNA was minted to try to restore the peg.

Confidence broke and investors started withdrawing their money as soon as possible to try and save what they could, exacerbating the fall. The death spiral had begun.

As part of managing the Terra/Luna ecosystem, Terraform Labs had created the Luna Foundation Guard (LFG), led by Do Kwon, which was designed to support the ecosystem and act as a backstop in cases of spiral.

Just weeks earlier, the LFG had bragged about buying large amounts of Bitcoin to act as a backstop for the UST peg. It said it had $3.5 billion in Bitcoin reserves — one of the largest single Bitcoin stocks in the world — that could be used to maintain the peg.

As Luna and Terra tumbled, LFG said it had staked the reserve (now valued at significantly less than what it was bought for, as Bitcoin’s value had also fallen due to the market’s downturn in May).

In public, it was still optimistic about the pen’s recovery. Just before the crash, Do Kwon posted this fateful tweet:

It turned out that the LFG reserve made little difference.

UST, which had fallen to 43c, made a brief comeback to 80c, before resuming its fall.

Meanwhile, LUNA’s value was in free fall. In its desperation to try and re-pair UST, the algorithm minted new LUNA tokens at a rate that would make the Zimbabwean Central Bank blush.

Before the collapse, there were approximately 340 million LUNA tokens.

By the time the network was shut down, there were approximately 6.5 trillion LUNA tokens.

The mold was gone. Tens of thousands of investors were left high and dry; Terra’s main subreddit unironically posted suicide and support helplines at the top of the page before shutting down the subreddit completely.

At the time of writing, Terraform Labs has made public statements about rebuilding the network — perhaps including a rollback to an earlier block — but trust in the network was gone.

Could it happen again?

In the days following the collapse, many questions were raised about stablecoins in general.

While backed stablecoins are a fundamentally different beast than algorithmic stablecoins, concerns have been raised about their, well, stability.

In theory, a backed stablecoin can’t lose its pen for long – unless the company backing it stops or starts refusing to exchange tokens.

Tether, the largest stablecoin by a significant margin, has lingering questions about its claimed reserves.

Company claims it has reserves to match the currently minted stock of USDT, held in various asset classes (including “commercial paper”), but it has not been publicly audited.

For many observers, this is a ticking time bomb – Tether has become fundamental to the cryptocurrency ecosystem.

It is the most common trading pair, serving as a “middleman” in many crypto exchanges, and used for transfers between exchanges.

A collapse of Tether, likely caused by a “bank run” where Tether can’t exchange the currency, could destroy the entire ecosystem for years.

It is not known how likely it is that this will happen. There are also backstops: USDC and BUSB are both monitored and have proven reserves.

Yet the lesson from Terra/Luna is that nothing in crypto is guaranteed.