Terra Network Collapse

The Terra network, comprising the LUNA and TerraUSD cryptocurrencies, collapsed over a period of three days in May 2022, erasing $45 billion in market capitalization almost instantly and contributing to billions more in losses in the wider crypto market. The collapse eventually led to the arrest of Terra’s founder, Do Kwon, on criminal charges.

At its peak, Terra was the third largest cryptocurrency ecosystem by market cap after Bitcoin and Ethereum. In addition to its native currency, LUNA, and its algorithmic stablecoin, TerraUSD (UST), the network also included the Terra blockchain, which hosted thousands of decentralized applications (dapps).

Starting on May 7, large withdrawals and sales of UST were observed by bots that monitor significant crypto transactions. The huge sell-offs de-pegged TerraUSD from its $1 value and started a panic in the market, sending the value of LUNA spiraling as well.

Despite attempts by Kwon to raise emergency funds, the entire network became insolvent in the following days. The collapse and the enormous loss of capital shocked the greater crypto community and generated public distrust in the crypto economy.

Background

Terraform Labs was founded in 2018 by Do Kwon, a South Korean entrepreneur and crypto personality, and Daniel Shin, another successful entrepreneur in the Korean tech space. The company’s mission focused on the rapid adoption of cryptocurrencies through usability and price stability.

Terraform Labs launched the Terra blockchain as a decentralized, open-source platform that hosts dapps and algorithmic stablecoins. By December 2021, Terra was the second largest blockchain by market capitalization after Ethereum.

LUNA and TerraUSD

Terraform Labs released LUNA, Terra’s native cryptocurrency, in August 2018. It operated similarly to how Ether functions on Ethereum, including payment for fees, staking (pledging coins to be used for verifying transactions), governance (allowing holders to vote on the funding for blockchain projects), as well as keeping TerraUSD stable.

The TerraUSD algorithmic stablecoin was introduced in September 2020. Stablecoins provide hedges against volatility in the crypto market and usually rely on collateral assets to maintain the peg. Most frequently, these collateral reserves take the form of traditional assets such as bank deposits or other money market funds. Tether and USDC, for example, are pegged 1:1 to the US dollar and are backed by bank deposits and money market assets to ensure each coin can be minted or redeemed in exchange for 1 USD.

However, pegging coins to traditional assets typically requires trusting a centralized authority to custody and manage the assets, such as a bank. Kwon thought this process was contrary to his beliefs of a decentralized system removed from regulatory and governmental censorship.

UST was created to avoid non-crypto reserve assets by using the LUNA token in the stabilization mechanism. In simple terms, every time 1 UST was made (“minted”), 1 USD worth of LUNA is destroyed (“burned”) via algorithms in smart contracts. Conversely, for each UST redeemed, 1 USD worth of LUNA would be minted. Through this mint and burn process, LUNA would essentially absorb the volatility of TerraUSD and would allow arbitrageurs a way to profit when UST deviated from its 1 USD peg.

The coins were initially enormously successful. This rapid rise in UST supply was largely driven by the extremely large rewards offered by the Anchor Protocol, also built by Terraform Labs, which offered 20% yields for users’ deposits of UST. These above-market rates were subsidized by Terraform Labs as a way to encourage adoption of UST, but many in the Terra Network community acknowledged that they were not sustainable in the medium- to long-term and would need to be phased out.

At their peak in April 2022, TerraUSD was the third largest stablecoin with a market cap of $17.5 billion, with approximately 75% deposited into the Anchor Protocol to earn rewards, and LUNA was valued at $117 USD, with a total market cap of more than $40 billion.

Criticisms of the algorithmic currencies

As early as 2018, economists and crypto experts expressed concerns about stablecoins not backed by a fiat asset, calling the currencies highly speculative and the technology experimental. Others warned that the self-correcting mechanisms of the currencies would quickly fail if there was a crypto bank run, causing a “death spiral” as both collapsed. Further, other algorithmic stablecoins, such as Iron and Titan, had failed in the past.

Collapse of the Terra network

On May 7, 2022, soon after Anchor Protocol began its efforts to lower UST yields and implement a more sustainable rate mechanism, a whale watching bot that monitors and tweets large crypto swaps revealed that 85 million TerraUSD were swapped for USDC. The same day, there were other large selloffs of TerraUSD on the Anchor lending platform and stablecoin exchange Curve. The value of TerraUSD dropped from its $1 peg to $0.985.

News of the selloffs and the de-pegging of TerraUSD spread quickly among the crypto community and started a panic in the market. Investors ran to withdraw their UST from Anchor and swap their LUNA and UST for other coins. Many in the crypto space started fearing that the Terra network would become insolvent. As users redeemed their UST, this resulted in more LUNA being minted which put downward pressure on LUNA’s price and further decreased confidence in the network, resulting in the vicious cycle of a “death spiral”.

In April, the Luna Foundation Guard (LFG), a non-profit run by Kwon, released its plan to purchase over $10 billion worth of Bitcoin to help keep UST’s peg. Kwon informed investors that they had already purchased $1.5 billion worth of BTC towards that goal.

On May 8, LFG released $1.5 billion in capital to add to the network’s liquidity. Kwon tweeted “steady lads, deploying more capital,” to reassure investors that UST could be brought back to its $1 peg. However, the flood of new funds did not quell investor fears and the value of the coins continued to spiral.

On May 9 alone, approximately 5 billion UST, 35% of the total 14 billion UST deposited to Anchor, was withdrawn from the protocol. By May 11, over 11 billion UST had been withdrawn from Anchor.

On May 12, the value of LUNA plunged 96% to less than $0.10 and many exchanges halted trading on the coin. By the next day, its value was essentially $0.

Impact on the cryptocurrency community

The crash had profound effects on the cryptocurrency market, leaving both investors and the general public shocked at how much value was wiped out in just a few days. Hundreds of thousands of investors were affected, including some individuals who had put their life savings into the LUNA coin. South Korea estimated that 28,000 of its citizens lost funds in the collapse. In addition to those who lost money, $28 billion in value was eradicated from decentralized applications of the Terra blockchain when customers abandoned the network.

The collapse extended to the entire crypto ecosystem by accelerating the loss of billions of dollars, and numerous brokers, lenders, and exchanges filed for bankruptcy. It also generated public distrust in a system that could lose so much value so quickly.

Investors in multiple jurisdictions, including South Korea, the US, and Singapore, pursued legal action against Kwon and Terraform Labs. US authorities said Kwon orchestrated “a multi-billion-dollar crypto asset securities fraud" and is wanted for many financial crimes, including securities fraud, wire fraud, conspiracy to defraud, and conspiracy to engage in market manipulation.

Kwon was arrested in March 2023 in Montenegro for forged passports and documentation where he is expected to serve a four-month sentence.