Crypto Contagion: The Collapse of Terra

Ponzis and other high risk behaviors thrive in bull markets, but are crushed in bear markets. When the crypto markets went from bull to bear in Nov 2021, the risk takers started imploding months later. The first domino to fall was Terra. 

Is Yield Farming Just a Ponzi?

Yield farming is the most popular use case of crypto. In order to incentivize users to deposit their crypto into specific DeFi applications, DeFi apps offered interest rates that were unheard of in traditional finance. The competition between DeFi apps for user funds is fierce, and users are fickle with their funds: they are constantly shifting their deposits to new applications offering better interest rates.  

In order to compete, the creators of Terra offered 19.5% yield for depositing UST into Anchor, a DeFi app running on the Terra blockchain. UST was a stablecoin native to Terra. Stablecoins are cryptocurrencies that are pegged (aka meant to match the value) of a different asset. Most stablecoins are pegged (tied) to the value of the US dollar. At the height of the ponzi, users deposited 12.6 BILLION dollars worth of UST into Anchor to receive the 19.5% interest rate. 

So how is UST tied to the US dollar?  

Unlike other stablecoins, UST isn’t backed by collateral. The creators of UST programmed a clever, but ultimately doomed, mechanism that helped peg the value of 1 UST to 1 US dollar. This mechanism incentivized traders to profit from helping maintain the peg across every exchange. Arbitrage traders were beautifully motivated to make purchases or sales of UST in order to constantly push the price towards 1 dollar. 

UST was successfully pegged to $1 before its downfall. source: coinmarketcap

Details And Examples

The incentive mechanism also involved another asset, the LUNA token. LUNA is the native asset of the Terra blockchain (LUNA is to Terra Luna, as ETH is to Ethereum). 

Here is the mechanism: 1 UST could always be redeemed for $1 worth of newly minted LUNA. When 1 UST is redeemed, it is “burned”: it is programmatically deleted and removed from the total supply. Conversely, $1 worth of LUNA could be redeemed (aka “burned” or deleted) to mint 1 brand new UST token. This redemption mechanism was managed by a special application on Terra called Terra Station. 

Here is how arbitrage traders made a profit when the price of UST moved away from $1.  Let’s say, that in the open market (aka an exchange like Kraken or Curve), UST was valued over 1 dollar at $1.01. In order to profit, I do the following: 

1. Purchase $1 dollar worth of LUNA on the spot market (any market)

2. Redeem $1 worth of LUNA for exactly 1 UST (LUNA is deleted, UST is minted)

3. Sell this UST on an exchange for $1.01 dollar

Now let’s say that the value of UST is $0.99:

1. Buy 1 UST on the spot market for $0.99

2. Redeem this UST for $1 worth of LUNA (UST is deleted, LUNA is minted)

3. Sell your $1 worth of LUNA on an exchange

When done on a large enough scale, arbitrage traders can make significant profits. 

So how does this push UST back to $1???

Let’s refer back to the first arbitrage example when UST is worth $1.01 on the exchange. Each time a trader executes the arbitrage trade, they sell UST on the open market, which pushes down the price: they are “selling down the order book.” The UST sold is also newly minted UST, which means they are increasing the total supply. 

Now let’s refer to the example where UST is worth $0.99. Each time the trader executes the arbitrage, they are buying USTs on the open market and then deleting them from the total supply while increasing the total supply of LUNA tokens. 

The House of Cards Trembles…

The economic mechanism stabilizing UST worked for ~1.5 years and then collapsed in spectacular fashion. On May 10 2022, the price of UST dropped to ~$0.66 after several days of instability across UST markets. This time, the incentive mechanism wasn’t enough to retain the $1 peg. 

Terraform Labs, the creators of Terra, and other affiliates used their massive war-chest of Bitcoin and other funds to backstop the price. From May 8 to 12, these organizations spent 1.7 BILLION worth of bitcoin and other stablecoins to put upward pressure on UST price. 

LFG | Luna Foundation Guard @LFG_org

2/ Consistent with its non-profit mission & focus on the health of the Terra ecosystem, beginning on May 8, when the price of $UST began to drop substantially below one dollar, the Foundation began converting this reserve to $UST.

…And Ultimately Collapses

The backstop helped pump the price back up to 90 cents for a few days, but then the incentive mechanism designed to stabilize the price of UST ultimately led to the downward spiral of both the UST and LUNA token. UST holders lost confidence that the asset would return to $1 so they redeemed as much UST for LUNA as they could. The supply of LUNA exploded. In a matter of days, the price of LUNA and UST were wiped out. The combined marketcap of LUNA and UST was over $45 billion at their height, but then collapsed to nearly 0. 

The marketcap of LUNA. source: coingecko

The Next Domino To Fall

Right before the Terra ecosystem collapsed, crypto markets had already been in freefall for 6 months. Crypto hedge funds and other companies with lots of crypto on their balance sheet were already feeling the pain. Lending firms lent billions of dollars during the bull market, but, after Terra collapsed, they started getting nervous. Could their debtors pay them back? 

Three Arrows Capital, a once revered crypto hedge fund, bet big on Terra and lost. Next post, I analyze their fall from grace.