Dreams, hopes, and life savings were destroyed this week when Terra (LUNA) collapsed. Less than two months ago, LUNA was ranked as the eighth largest cryptocurrency with a market cap of $36.8 billion.[1] This week LUNA has lost 99.9% of its value. The subreddit r/terraluna is now a place for suicide contemplations and stories of bankruptcy. What happened?

Due to the relatively complex nature of TerraLUNA, the incident has escaped extensive coverage from the press. The average news consumer is still thinking of Bitcoin as a shady currency for tax evasion and money laundering with a damaging environmental impact. Sadly, this type of close-minded thinking is a hindrance to any further dialogue between policy makers and the crypto community about how to best regulate or implement cryptocurrencies in society, or how to pave the way for Web 3.0. Meaningful dialogue about these matters is urgently needed so the public can take advantage of new technological opportunities, while also limiting Big Tech’s privatized iron grip on democratic institutions.

In this post, I will take on the challenge of briefly explaining how TerraLUNA worked (“worked” assuming it will not recover) and how it crashed. In the last part of the post (which is much easier to read and understand) I will give a warning about internet scams that may increase in frequency and intensity in sync with the waves of fear and greed in crypto.

The Terra Ecosystem

Terra was a public blockchain protocol backed by a stablecoin called TerraUST (UST). Terra hosted a whole ecosystem of DeFi applications that was brought down with it. Here is an illustration of how large the ecosystem was.

Stablecoins are crypto assets that track the price of an underlying currency or asset.[2] They are used as a reliable medium of exchange and as a hedge against the wild price fluctuations of digital assets like Bitcoin or Ethereum.[3]

UST was pegged to the price of the US dollar. So are the largest stablecoins Tether and USD Coin, respectively the third and fourth largest cryptocurrency by market cap.[4] The price of Tether and USD Coin is guaranteed by currency reserves and other liquid assets which should fully match up to the value of each stablecoin. In contrast, UST was a so-called “algorithmic stablecoin” not backed by any collateral.

The idea of an algorithmic stablecoin is to use the market forces of supply and demand to maintain price stability. The Terra protocol used a “two-coin” system, where one coin (UST), is used to maintain the peg, while the other (LUNA) is used to “absorb” market volatility.[5] The price of UST and LUNA is thus closely related.

LUNA was (technically still is) the native token of Terra — like Ether is the native token of Ethereum. It was used for staking (validating transactions and minting new tokens) and governance (casting votes in the system), and most importantly in this context as collateral for UST. Instead of assets, UST’s 1:1 peg with the dollar was backed by an algorithmically coded arbitrage mechanism.

Arbitrage occurs when a user profits from price differences between markets. The Terra economy can be thought of as two distinct markets or pools, one pool for UST and one pool for LUNA.[6]

Each time 1 UST is swapped for 1$ of LUNA, 1 UST is removed from the UST pool (burned), and 1 LUNA is added (minted) to the LUNA pool. And vice versa. If the price of 1 UST would deviate from the price of 1$, users would be incentivized to swap LUNA-UST or UST-LUNA to settle the price difference.

It works in this way: If 1 UST was trading for the price of 1.01 $, users could burn 1$ of LUNA in exchange for minting 1 UST, thus profiting 0.01 $ through arbitrage. If on the other hand, 1 UST was trading for 0.99$, users would trade 1 UST for 1$ of LUNA, thus profiting 0.01$ from the swap.[7]

The TerraLUNA Crash

The Achilles heel of TerraLuna was the Anchor Protocol that offered investors a market-leading yield of 20% for depositing USDT on their platform.[8] The promise of high yields inspired many unfortunate investors to place their hard-earned savings on Anchor. After a series of large withdrawals from the Anchor platform, UST began de-pegging from the dollar on the 7th of May which led to a wider-scale panic sell-off.[9] According to the co-founder of Terra, Do Kwon, the algorithm could not facilitate the minting of new LUNAs at a speed needed to re-peg UST.[10]

Some commentators claim that the sell-off was due to a coordinated attack, while others point to the souring wider market conditions, especially in the price of Bitcoin.[11] Do Kwon sat up Luna Foundation Guard in February 2022 with the goal of buying $10 billion in bitcoin over time to protect UST’s peg. [12] The fund has now been largely depleted after $3 billion in bitcoin, Tether, and LUNA was spent in an emergency effort to maintain the peg which according to WSJ contributed to a sharp drop in bitcoin’s price. [13]

The TerraLUNA crash was unforeseen by many, but not by all.

Law professor Ryan Clement from the Canadian University of Calgary Faculty of Law warned against the use of algorithmic stable coins in his paper Built to Fail: The Inherent Fragility of Algorithmic Stablecoins in October 2021. He foresaw the “death spiral” that occurred when investors lost faith in UST’s price stability.[14]

In November 2021, Twitter user Freddie Raynolds provided a detailed breakdown of how a wealthy attacker could profit heavily from breaking down Terra. Do Kwon arrogantly dismissed the thread as “retarded”.

A report from Swissborg (April 2021) accurately predicted how Anchor Protocol’s high lending rates could put stress on UST’s peg to the dollar and trigger the UST-LUNA “death spiral”.

“Crypto stars” such as co-founder of Ethereum, Vitalik Buterin, and CEO of FTX, Sam Bankman-Fried, even hinted at the troubles with undercollateralized stablecoins weeks before the crash.

Scams in Desperate Times

The crash of TerraLUNA has raised shock waves throughout the crypto market amidst an already unstable world economy plagued by the ongoing war in Europe and the aftermath of COVID.

In desperate times, people are more vulnerable to scams and rash decision-making.

During the critical days of the TerraLUNA crash, I noticed several videos like these in my YouTube recommendation feed:

The video description looks normal. The MicroStrategy channel looks legit at a sight with 692k subscribers.

Here are the highest-ranking results when I made a YouTube search for “MicroStrategy”:

All the videos link to BTC and ETH “giveaway sites” such as the one screenshotted below (mstbtc.vin) featuring a “Rules & Information” page, QR codes for participation, a feed of live transactions, and a customer support chat.

Big crypto community names, in this case, Michael Saylor and Micro Strategy, are exploited to lend ethos and credibility to the scammers. Granted, you have to be unusually blue-eyed and reckless to fall into a trap like this without doing a background check on the” giveaway”. But then again, crypto is hopium for people. A hopeful hodler with a portfolio in red may see a golden opportunity that for a minute or two overturns their common sense. And so, disappears billions of dollars each year[15] with an almost non-existent chance for recourse.

Scams like these are not a problem of the crypto world. They are a problem of the internet. Misinformation campaigns and decidedly scams are able to roam freely in the high end of search result rankings and recommendation feeds where they are mixed in with everything else.

Algorithms that curate content on social media are great at capturing people’s attention, but cannot tell the difference between a dog and a bird, a scam, or a helpful video. Cool websites, social media profiles, and even images and videos are often made with the sole purpose of deceiving us. They present a false reality to cover a hidden motive. Be aware.

Also Published Here

[1] Andrew Asmakov (March 2022), Terra’s LUNA Sets New All-Time High Following $135 Million Bitcoin Buy -> https://decrypt.co/96286/terras-luna-sets-new-all-time-high-following-135-million-bitcoin-buy

[2] Terra Docs, About the Terra Protocol -> https://docs.terra.money/docs/learn/protocol.html (14–05–2022).

[3] Gian M. Volpicelli (May 2022), Terra’s Crypto Meltdown Was Inevitable -> https://www.wired.com/story/terra-luna-collapse/ (14–05–2022).

[4] https://coinmarketcap.com/coins/ (14–05–2022).

[5] Ryan Clement (October 2021), Built to Fail: The Inherent Fragility of Algorithmic Stablecoins, 11 Wake Forest L. Rev. Online 131, pg. 137.

[6] Terra Docs, About the Terra Protocol -> https://docs.terra.money/docs/learn/protocol.html (15–05–2022).

[7] Ibid.

[8] Sam Kessler & Sage D. Young (May 2022) The LUNA and UST Crash Explained in 5 Charts : https://www.coindesk.com/layer2/2022/05/11/the-luna-and-ust-crash-explained-in-5-charts/

[9] Ekin Genç (May 2022), Algorithmic Stablecoins: What They Are and How They Can Go Terribly Wrong -> https://www.coindesk.com/learn/algorithmic-stablecoins-what-they-are-and-how-they-can-go-terribly-wrong/ (15–05–2022).

[10] Ibid.

[11] Ibid.

[12] Ibid.

[13] Caitlin Ostroff (May 2022), Why Did Cryptocurrencies TerraUSD and Luna Unravel? Stablecoin Price Crash Explained -> https://www.wsj.com/articles/why-did-cryptocurrencies-terrausd-and-luna-unravel-stablecoin-price-crash-explained-11652462779 (15–05–2022).

[14] Krisztian Sandor (May 2022) Investors Flee Terra’s Anchor as UST Stablecoin Repeatedly Loses $1 Peg https://www.coindesk.com/markets/2022/05/09/investors-flee-terras-anchor-as-ust-stablecoin-repeatedly-loses-1-peg/ (16–05–2021).

[15] Chainalysis Team (Jan 2022) Crypto Crime Trends for 2022: Illicit Transaction Activity Reaches All-Time High in Value, All-Time Low in Share of All Cryptocurrency Activity https://blog.chainalysis.com/reports/2022-crypto-crime-report-introduction/