Dragonfly Capital partner reviews the Terra incident: Algorithmic stablecoins need strong regulation

Author: Haseeb Qureshi, Dragonfly Capital

Compiled by: Odaily Planet Daily

Terra will be forever remembered by the crypto market.

Terra was initially designed to create an experimental stablecoin. In just one year, Terra became one of the best-performing assets of this cycle, and it also experienced the most spectacular collapse of a mainstream coin in history. The impact of Terra's failure will resonate throughout the industry in the coming years, and people's impressions of DeFi and decentralized stablecoins will be "significantly diminished."

Source: CoinMarketCap. The price of Terra (LUNA) since 2020.

The Rise of the Terra Empire

In 2018, Terraform Labs, the company behind Terra, started with the positioning of a decentralized algorithmic stablecoin, with the initial vision of creating a stablecoin pegged to major currencies to reduce e-commerce transaction costs and facilitate real-time payments. The two founders, Do Kwon and Daniel Shin, are both South Korean serial entrepreneurs educated in the United States. Daniel Shin was a co-founder of TMON, one of South Korea's largest e-commerce companies, and after leaving Terraform Labs, he managed Chai, a Korean commercial payment platform supported by Terra.

In the early days, Terra only facilitated e-commerce payments in South Korea, with almost all payments made through the Chai payment platform. However, after the DeFi Summer of 2020, Do Kwon had a brilliant idea: to expand the Terra blockchain to support smart contracts and create a native DeFi ecosystem centered around the dollar-pegged stablecoin UST to increase adoption. (Prior to that, the largest stablecoin on Terra was KRT, pegged to the Korean won.)

Source: CoincuTotal. Total transaction volume of Terra since 2021.

This strategy achieved tremendous success. By 2021, Terra's popularity surged from $0.63 to $91.38, appreciating 145 times.

The core of this rapid growth came from the deposit protocol built by Terraform Labs, Anchor protocol. Dragonfly Capital was one of the seed round investors in Anchor. Anchor accepts UST and yield-generating assets (usually liquid stock derivatives like stETH), and due to the passive yield generated by staking derivatives, these yields are captured by the protocol and used as interest rates to subsidize depositors.

Source: Anchor Protocol. Anchor's slogan.

The most important (and controversial) feature of Anchor is that the protocol set a fixed target yield for depositors, rather than a market-driven interest rate. From the beginning, this rate was set at around 20%. To achieve this yield, Anchor contributed additional interest payments from UST's on-chain reserves, funded by Terraform Labs.

In the early days of Anchor, this interest rate was basically sustainable because the overall interest rates in DeFi were also high. As most DeFi protocols' yields declined in the summer of 2021, Anchor still refused to change its target rate. This made Anchor's guaranteed yield of 20% increasingly attractive, and it eventually became the lending protocol with the largest TVL in all of DeFi.

Source: Dune Analytics. Compound USDC interest rates since early 2020.

The amount of deposits in Anchor rapidly expanded, beginning to become inconsistent with the growth of loans.

Source: Anchor Protocol. The growth of Anchor deposits and loans over time (peaking at its collapse).

At this point, a small ecosystem of banking startups emerged. They used Anchor as the asset side, offering customers a nominal yield of 20%. Even special purpose vehicles (SPVs) for Anchor appeared, obtaining dollars from family offices and marketing the 20% yield.

More and more UST began to be minted, only to be deposited into Anchor. At its peak, Anchor held over $14 billion in UST, making UST the third-largest stablecoin in the world.

Source: Messari. UST supply before May 8.

Is the 20% yield of UST sustainable?

When over $10 billion in UST was promised a 20% yield, paying over $2 billion in interest annually, and could not be covered solely by the interest paid by borrowers, it was clear that the reserves would quickly deplete.

Source: Flipside Crypto. Anchor's yield reserve fund underwent a capital restructuring with $450 million in mid-February.

In February 2022, facing dwindling on-chain reserves, Do Kwon was forced to quickly restructure the reserves with $450 million in UST. Dynamic adjustments were key to keeping UST afloat.

Anchor, as the "tumor" at the center of Terra, needed to be fed. Its greedy appetite also made UST the fastest-growing stablecoin in the entire industry.

Since high yields are unsustainable, why not stop it earlier?

The support for Anchor's high yield was simple: the massive adoption of UST. The growth of UST and the reflexive price of LUNA attracted new developers and projects to Terra, reinforcing this cycle. They believed that the yield was merely a customer acquisition cost that had to be paid before UST became the dominant stablecoin in cryptocurrency.

Source: Anchor Protocol. Comments from the Anchor governance forum.

Like many others, we publicly commented on the unsustainability of UST and Terra, but Terra dismissed these comments. Do Kwon formed a cult of personality around himself, publicly attacking detractors and dismissing claims of "unsustainability."

Source: Twitter. Do Kwon publicly bet $1 million on Terra's future solvency against Algod, who publicly condemned Terra as a Ponzi scheme. Do Kwon publicly bet against other critics for a total of $11 million.

The Terra community now heavily relied on Anchor. Ultimately, the market cap of LUNA was more than twice the value of outstanding UST. At this point, some still believed that even at such growth levels, UST was a safe over-collateralization.

To alleviate the debt pressure from rapid growth, Terraform Labs established the Luna Foundation Guard (LFG) to support UST's peg. Notable members included Jump Capital, a venture capital firm under Jump Trading, and Delphi Digital. Jump is one of the most profitable market makers in all of cryptocurrency, reportedly making billions in profits last year, a significant portion of which came from massive bets on the Terra ecosystem.

LFG raised $1 billion, led by Jump Capital and Three Arrows Capital, and began building a Bitcoin reserve to diversify the single reliance on UST. This was a supplement to its initial funding of $72 million (which was nominally worth over $5 billion at the time). LFG publicly purchased nearly $3 billion in BTC, aiming to buy up to $10 billion in BTC, thus becoming one of the largest known holders of BTC, all to support UST's reserves.

The Terra community once believed that its central bank was now so financially robust and unbreakable.

The Trigger and Climax of the Collapse

In early Q2, due to concerns about inflation, risk assets, and the cryptocurrency market, some holders began to sell off, and the ratio of LUNA to UST's market cap rapidly declined.

Source: CoinMarketCap. LUNA's market cap after mid-January.

This decline peaked on May 9. To preemptively address larger-scale sell-offs, some whales withdrew large positions from Anchor and sold UST through Curve, the largest DEX for UST. Hundreds of millions of dollars in sell orders in a short time ultimately caused UST to decouple.

This triggered panic. More and more Anchor users began to withdraw and sell their UST, exchanging it for LUNA and then cashing out LUNA. LUNA's market cap plummeted from $22 billion to $11 billion in just a few hours, evaporating 50% of its market cap, exceeding the 100% collateral threshold.

This led to UST suddenly becoming under-collateralized.

Source: TradingView. On May 9, as LUNA's price fell, UST's peg broke (red line).

The market reacted violently. Anchor depositors rushed to exit before UST and Anchor were completely burned, leading to a bank run.

Source: Anchor Protocol. The total deposits in Anchor plummeted in May as users rushed to withdraw funds.

LFG armed itself with billions of dollars in LUNA and BTC assets, desperately trying to buy the UST being sold, but the sell-off could not be stopped. When on-chain "detectives" discovered that LFG had transferred $1.4 billion in Bitcoin assets to Binance, the entire market panicked over concerns that Bitcoin would be sold in an already chaotic environment. Ultimately, as many warned, Bitcoin did not alleviate market panic at all. During times of panic, the correlation of crypto assets is 1. Bitcoin's crash led to further declines in LUNA.

Do Kwon and the Terra community still believed that restoring the peg was just a matter of time. Many thought that the massive capital supporting LFG—billions in BTC and LUNA, along with vested interests from Jump Trading, Three Arrows Capital, and others—made Terra too big to fail.

But in the following hours and days, UST's peg gradually fell as LUNA's price declined.

Source: CoinMarketCap. UST/USD exchange rate since May 8.

Rumors circulated about large margin calls, and funds and market makers exposed to LUNA and UST risks had to sell at discounted prices. The entire market fell in sync.

As more UST was redeemed for LUNA, LUNA had to mint at an increasingly rapid pace to meet all redemptions. Initially, LUNA had a daily cap on its minting rate (up to 290 million UST redeemed per day), but to attempt to clear the backlog, validators voted to release this cap and mint faster. However, the market could not absorb these sell-offs. Terra's algorithmic minting led it into a vortex of hyperinflation, much like a third-world country frantically printing devalued currency to repay its creditors.

Source: TerraScope. The malignant inflation of LUNA supply.

Three days later, LUNA's supply surged from 345 million to 6.5 trillion, an expansion of about 18,840 times. On May 12, LUNA was delisted from several major exchanges, with its price dropping from over $60 to less than a tenth of a cent. The Terra blockchain halted block production as the cost of governance attacks had dropped to a few million dollars, allowing anyone to take over the chain and cause severe damage.

At this point, the game for Terra was over.

But two questions remain for us.

First, what can Terra do now?

Rumors suggest that LFG still holds over $1 billion in unused Bitcoin, and Terra remains an L1 with an emerging ecosystem. When the central bank of an L1 is in debt exceeding its assets, there is only one responsible thing to do: default on the debt and negotiate with creditors.

If Terra negotiates a compensation plan acceptable to UST holders, perhaps the Terra chain can survive. But instead, under their operations, LUNA was excessively inflated, losing all purchasing power, rendering the blockchain itself worthless. (Now, Do Kwon has proposed "Rebuild Terra Ecosystem Plan 2," suggesting forking the Terra chain into Terra Classic and a new chain without algorithmic stablecoins.)

Second, what long-term consequences will Terra's failure bring?

The most obvious is that algorithmic stablecoins like UST will no longer be taken seriously. Since the original algorithm for stablecoins—the Basis whitepaper—was released, the possibility of a death spiral for stablecoins has been known. Terra's failure has etched it into the collective memory of crypto participants. Every major algorithmic stablecoin has either completely failed or significantly devalued in the past week.

This was the largest-scale experiment, and the collapse of Terra may be the death knell for algorithmic stablecoins.

The second consequence of Terra's bankruptcy is strong regulation. Regulation of stablecoins and DeFi is likely to be introduced soon, and it will be more punitive than ever before. The last time we saw such a shocking public failure of a large crypto asset was the collapse of the Ponzi scheme BitConnect in 2018. Its promoters have been sued by the U.S. Securities and Exchange Commission. For a failure of this magnitude, people must be held accountable. We have already seen U.S. Treasury Secretary Yellen calling for regulation of stablecoins and holding congressional hearings on the risks of DeFi.

Ultimately, the collapse of Terra is a story of hubris and foolish growth at all costs. Taking risks and engaging in open innovation are at the core of entrepreneurship and the purpose of DeFi. However, with great freedom comes great responsibility, and when this responsibility is neglected, we will ultimately pay the price.