Last week, these headlines were all over the news:
For the past few weeks, we talked about the mint/burn mechanism on the Terra blockchain. This specificity drove yields on DeFi protocols up. However, as we explored in this article, the peg to USD can be difficult to maintain under certain circumstances.
One of these circumstances happened last week, as some entity with deep pockets took a $1B loan in UST. They used this loan to drain liquidity from the Curve 4Pool. Curve is a DeFi liquidity pool based on the Ethereum blockchain. The Curve pools allow more accessible and cheaper stablecoin exchanges. Here, since the loans were too important, it was difficult to perform on-chain swaps and mint/burn. Consequently, this event started the initial depegging.
Once the 4Pool was drained, large UST short positions were taken on Binance which threw the UST peg off by more. It is likely that there was a LUNA short as well. The lack of liquidity to perform on-chain swaps and the massive sell pressure on CEX caused a race to exit by all investors. Eventually, UST tanked to 30c and LUNA dropped nearly to 0.
Initially, Binance and FTX suspended spot and futures trading for LUNA/UST. However, they resumed spot trading shortly after, which allowed more liquidity into LUNA and UST. This was a signal that Terra was not dead yet.
Unfortunately, neither LUNA nor UST managed to gain back enough value. Eventually, Terra blockchain was halted by validators… and you probably saw this tweet:
This event demonstrated poor crisis management from Luna Foundation Guard (LFG) as they should have halted the system earlier. This would’ve saved precious time for LFG and Terraform Labs (TFL) to make the necessary changes to keep Terra alive.
The main objective was to restore the UST peg. Therefore, they increased LUNA dilution by 700 billion tokens. This undertaking resulted in a severe crash of LUNA and a definite failure to restore the UST peg. The lack of liquidity from LUNA prevented this restoration. In other words, LUNA was not worth enough to recover the billions lost in UST.
Since the crisis, multiple proposals have been brought to light. One of which is to preserve the community and the developer ecosystem, validators should reset the LUNA supply to 1B tokens and the distribution should go as follows:
- 40% to LUNA holders before depeg;
- 40% to UST holders pro-rata at the time of network upgrade;
- 10% to LUNA holders at the final moment of the chain halt, and;
- 10% to the community pool to fund future development.
LFG is looking to use its remaining reserves to compensate remaining users of UST. We are currently waiting for updates to follow on distribution.
Numerically speaking, Terra’s $50B market cap was lost. However, loss of trust in DeFi protocols or in the entire crypto ecosystem, including lending/borrowing protocols and stablecoins might be the true cost of this fiasco.
What can we learn?
First of all, Do Kwon, the Terra blockchain founder, is not at his first failure. His support for Degenbox (MIM algo stable farming) was a red flag. The Degenbox strategy allows users to deposit wrapped UST into smart contracts to mint MIM, which can then be sold on the MIM/UST pool to increase one’s liquidity position via leverage. The fact that Do Kwon supported such a strategy was blatantly irresponsible because it set the scene for deep pockets entities to take advantage of the situation. (Spoiler alert: it happened.)
Secondly, onboarding the next few billions only through UST lending on Anchor while not adding anything else on Terra was a bad sign for the sustainability of the ecosystem. Furthermore, listing UST on highly liquid centralized exchanges like FTX and Binance caused UST to trade at different prices than on-chain swaps. Indeed, derivatives and futures contracts made it even worse because of the added leverage.
Last, we can point out the fact that Do’s personality created many enemies, as the destruction of LUNA and UST were the result of a targeted attack (either an individual or an entity). Plus, the health of on-chain liquidity was a weak point for mint/burn.
Finally, and this is probably the most important point: when dealing with any protocol, blockchain or cryptocurrency, it is essential to avoid any cult behavior. The Terra community has always averted attention to risks in Terra’s mint/burn mechanism. There were rarely any community members that would admit to the risks of UST depegging. This cult-like behavior can mislead inexperienced crypto investors to invest their life savings into Anchor, like we have seen the past week. Terra blockchain offered several opportunities to increase one’s return; however, the downfall was terrible for many.
Agnosticity and Risk Management is key when evolving in such a risky environment.