An In-Depth Review of the UST and LUNA Collapse

The collapse of TerraUSD (UST) and LUNA not only cost investors more than $40 billion, leading to hundreds of thousands of users to lose their money, but also single-handedly crashing the cryptocurrency market. As Terra and its network unraveled, many harrowing stories emerged of those who bought UST or LUNA and lost all their savings. And despite its founder Do Kwon’s open discussion of a revival plan and compensation for losses suffered by the community, this has not been universally popular. With the benefit of a few days distance from the dramatic events what can we say with more certainty about what caused the collapse?

What the hell happened to Terra?

The entire cryptocurrency market is currently experiencing a downturn in value, which looks set to remain in a slump for the remainder of 2022. Compared with other cryptocurrencies, the 20% interest rate offered by Terra’s Anchor protocol was particularly eye-catching to crypto bargain hunters, and which sucked in a significant amount of deposits on the platform in the short space of time. Although the project team tried to increase the enthusiasm of Anchor users to borrow, but under the influence of bear market pessimism, this incentive measure failed. As reported in The Verge following the collapse of Anchor: “The most charitable thing you could say about that 20 percent rate is that maybe it was meant as a customer acquisition strategy, and the APY was going to be revised lower later. Other people said other things. For example, some said it looked like an obvious Ponzi scheme, where money from later investors was paid to earlier investors as “interest.” I’m sympathetic to this argument since even Bernie Madoff didn’t consistently give his investors 20 percent interest rates.”

As a lending platform, Anchor Protocol’s deposit volume was much higher than the borrowing volume, with the loan interest income failing to cover the deposit interest rate expenditure, resulting in a huge gap between the income and expenditure. This caused a large number of users to choose to withdraw UST from Anchor Protocol and instead exchange it for other more stable assets. And critically when some people started doing this, the signs of UST price instability began to show, and panic started to spread. When people started to sell UST to LUNA frantically, it caused the UST price to break down, and the supply of LUNA in the market surged, causing its price to fall, creating a death spiral will begin, which LUNA and UST were unable to extricate themselves from.

A review of the UST and LUNA collapse

When you seek to understand the logic of the series of seemingly unpredictable events, it appears the collapse of LUNA and UST is not as accidental as it may seem.

• On May 8, the Luna Guard Foundation (LFG) whose job was to maintain the stability of the stablecoin UST withdrew $150 million of UST from the UST-3Crv liquidity pool in order to form the 4Crv liquidity pool, resulting in a drop in liquidity. Coincidentally, a sudden sell-off of 85 million UST from a new address severely affected the balance of the 3Crv liquidity pool. In order to maintain the balance of the liquidity pool, LFG withdrew another $100 million of UST from the capital pool. At the same time, multiple whale accounts began to continuously sell UST, resulting in more than $2 billion in UST flowing out of Anchor that same day. Affected by the sell-off, UST began to de-couple from its 1:1 peg with the US dollar. In turn, people started exchanging their UST holdings for LUNA, causing the supply of LUNA to increase and its price to drop to a low of $59.58.

• On May 9, LFG announced that it would use the Bitcoin reserve funds to loan $750 million to help stabilize UST, but despite the action the sell-off did not end, and UST further deteriorated, falling below US $ 0.98 on the same day, with user fear intensified. Users exchanged their UST for LUNA, causing the price of LUNA to drop by more than 50% again, and the death spiral began.

• On May 10, with nearly $6 billion of UST was withdrawn from Anchor, the price of LUNA plummeted to a new low of $14.15, and a large number of users began to buy LUNA at the bottom. Subsequently, UST fell to just $0.68.

• On May 11, Terra’s co-founder Do Kwon tweeted that he could not save the market and could only rely on the arbitrage mechanism to help restore the price of UST. Following the tweet, the LUNA price fell again by more than 95%, below $1, and UST plummeted to $0.29.

• On May 12, LUNA fell more than 99%, driving the price of the currency to almost zero, with the price of UST falling below $0.20.

• On May 13, following the collapse many cryptocurrency exchanges delisted LUNA and suspended trading, and the Terra public blockchain was shut down.

• On May 14, Do Kwon tweeted that he did not sell any LUNA, and that the team had prepared a new proposal to help LUNA rebuild, which led to the price of LUNA rising slightly.

• On May 18, Do Kwon tweeted that the #1623 governance proposal to rebuild the Terra network was up for voting: “Terra governance prop #1623 to rename the existing network Terra Classic, LUNA Classic ($LUNC), and rebirth a new Terra blockchain & LUNA ($LUNA) is now live.” The so-called ‘Terra Ecosystem Plan 2’

proposal included a hard fork and the removal of the stablecoin mechanism. The existing chain would be renamed Terra Classic (tokens renamed LUNA Classic, LUNC).

The new chain would continue to use Terra (LUNA) and will hold the old tokens, allowing owners, stakers, and developers conduct airdrops. As reported in Yahoo Finance, “the new chain would entirely cut out the failed UST product and instead focus on decentralized finance (DeFi) applications building on Terra, as reported. The current chain would continue as Terra “Classic,” while holders of LUNA on the “Classic” chain would receive a token airdrop of the new chain’s token under the plan.”

• On May 21, in a controversial move Do Kwon tweeted the burn address to help users burn LUNA. This move caused LUNA to rise in price by more than 88% in a short time. Burning means to permanently remove a part of the currency from the market circulation, ensuring that the number of coins in circulation will be permanently reduced, which will directly cause deflation, with the effect of increasing currency prices.

Despite these moves to salvage Terra the situation has not improved. A further proposal #1299 to rescue over 154.7 million UST stuck in Osmosis and side chains was put forward by Terraform Labs only to fail “due to technical reasons.” As reported by FX Street, “As a result of this failure, UST and LUNA tokens stuck on side chains will be excluded from the launch snapshot, thereby resulting in losses for community members. The rescue proposal 1299’s execution is key to a potential Terra’s LUNA price successful recovery.”

Meanwhile, on May 23, it was revealed that Seoul Metropolitan Police Agency’s Cyber Crimes Investigations Unit was investigating reports that an employee of Terraform Labs was involved in embezzling corporate funds. And with Terraform Labs and the LFG both registered in Singapore, it’s clear that it was in breach of the Payment Services Act 2019 which requires the likes of stablecoin providers to have a Digital Payment Token Services (DPTS) licence. As reported in Al Jazeera, BigONE Chairman Anndy Lian said the failure to register is one of three interrelated factors that provide compelling grounds for legal intervention. The second being is that this was a stablecoin, and the third the fork: “I think the Singaporean government will surely take some action after the fork is attempted. Because this is a global event, there might be a common interest for the US and Singapore to work together on this case,” Lian added.