May 23, 2022|Market Insights- 3 min
Source: CoinGecko
The financial and reputational damage, not only to Terra and its investors, but to the crypto-ecosystem as a whole, has been immense. Investors can learn from the story.
Some useful context
Most people are familiar with the cryptocurrency Bitcoin, which has grown in fame as its price has skyrocketed in recent years. Cryptocurrency is part of a broader movement known as Decentralized Finance (DeFi). The vision of DeFi is to create an alternative financial system based on blockchain technology.[1]
The main benefit of a DeFi system is that traditional intermediaries such as banks are eliminated. Transactions are conducted safer, faster, and cheaper via the blockchain. In the past few years, many firms have created DeFi-based solutions for remittances, lending, trading, and even insurance.
An important component of a DeFi system is the “stablecoin.” Most cryptocurrencies are too volatile (despite the name) to be used as currencies. To provide a currency that can be used within a DeFi system, firms such as MakerDAO and Tether have created crypto tokens that can be redeemed for the value of a stable currency like the US dollar.[2]
Most stablecoins are collateralized with the original currency. The issuer holds a supply of the original currency to back it up.
The Terra ecosystem
The original vision of the Terra project was grand. The founder, Do Kwon, wanted to build a complete, definitive DeFi system on its own blockchain. The Terra ecosystem initially consisted of a payments service (Chai), an investment platform (Mirror) and a savings product (Anchor).
It also had its own basket of stablecoins, the most popular of which was its US dollar stablecoin known as terraUSD (UST). This stablecoin was not collateralized by the US dollar or any external currency. Instead, it maintained a 1:1 “peg” to the US dollar through an ingenious algorithm that played a leading role in Terra’s downfall.[3]
A mass of detail surrounds the failure of Terra, but two essential issues led to the crash:
The ability of the UST to maintain its value depended on the value of LUNA, the main token of the Terra project. A main token is like a stock, representing the value of the whole Terra ecosystem, and the confidence of the market in its future.
To encourage adoption of the UST by the DeFi community, the Terra platform offerred 20% interest for UST holdings deposited in the Anchor savings platform. These rates succeeded in attracting large amounts of capital to UST.
How it unwound
Following a platform proposal in March, Terra introduced floating interest rates for the Anchor platform from May 1, which reduced the interest rate by 1.5% (from 19.5% to 18%).[4] This, and the promise of further rate cuts, placed depositors on high alert for any sudden movements.[5]
The sudden movement came on May 7, when UST was briefly “depegged” (lost its 1:1 peg to the reference currency) following a sudden sale of $85 million worth of UST on the Curve exchange. This triggered a “death-spiral.”
Funds began to flow out of the Anchor savings platform as panicked depositors sold their UST. This shook confidence in the whole Terra platform, leading to a decline in the price of LUNA, the collateral for UST. This decline prompted further withdrawals from Anchor, accelerating the cycle.
By the end of the week, the price of LUNA had fallen 99.99% (to effectively zero). Despite Terra deploying large amounts of capital to bid up the price of UST, the so-called “stablecoin” had collapsed in value to less than 20 cents. The project team was forced to switch off the Terra blockchain, admitting defeat.[6]
Lessons for investors
While Terra was based on genuinely novel technology and a futuristic vision of finance, its implosion bears the hallmarks of similar schemes that have failed in the past.
Some investments make impossible promises. Investors want these promises to be true and ignore the warning signs.
The idea of minting dollars out of thin air (i.e. without collateral) is attractive but unsustainable. Several similar projects have already failed in the short history of blockchain.[7] Even the founders of the Terra project may have realized this before the crash, purchasing a substantial quantity of Bitcoin to use in case the value of the UST coin collapsed.
Another warning sign was the offer of 20% interest on a savings product. Such a rate is unsustainable, but it attracts (as Terra did) a large amount of fickle capital that vanishes at the first sign of trouble, causing great instability.
The final lesson is that many smart investors were duped (including the Terra team themselves possibly). Common sense disappears when an idea gains momentum. FOMO (Fear of Missing Out) sets in.
Ralph Waldo Emerson, the 19th Century American philosopher, said that common sense is as rare as genius. With new technology and ideas, it is common sense to consult a trusted financial advisor that can spot the warning signs and offer objective judgement.
[1] “DeFi and the Future of Finance” - https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3711777
[2] CoinDesk - https://www.coindesk.com/learn/what-is-a-stablecoin/
[3] Decrypt - https://decrypt.co/resources/what-is-terra-algorithmic-stablecoin-protocol-explained
[4] Cryptonary - https://www.cryptonary.com/anchor-protocol-launches-floating-interest-rates-down-by-1-5-this-week/
[5] Decrypt - https://decrypt.co/98482/we-need-to-talk-about-terras-anchor
[6] Business Today - https://www.businesstoday.in/crypto/story/terra-blockchain-halted-again-as-crypto-tanks-9999-333416-2022-05-13
[7] Fast Company - https://www.fastcompany.com/90751716/panics-and-death-spirals-a-history-of-failed-stablecoins
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