Experience and Lessons: A Review of the Rise and Fall of the Terra Empire

Author: Beichen, Chain Teahouse

It seems that discussing the collapse of Terra has lost its timeliness. After the brief shock when the first domino fell, people's attention turned to chasing a series of subsequent reactions.

Terra lost $60 billion in just a few days, affecting the entire crypto market, which collectively lost over $300 billion, with no signs of recovery in sight (although there are still some uninformed newcomers on Twitter shouting to buy the dip).

Countless investors achieved financial freedom at the account level through Terra, only to return to square one, or even before that. This situation has occurred countless times in history and will continue to happen in the future. Despite the continuous accumulation and summarization of experiences and lessons, there will always be new investors entering the market with capital and impulse.

Let us also return to the starting point of Terra and summarize the experiences and lessons from its rise and fall.

Speculation is like pornography; it's hard to define, but a discerning eye can easily recognize it.

Many people attribute the collapse of Terra to someone harvesting retail investors. The various conspiracy theories simply suggest that the perpetrators come from a combination of Wall Street capital, exchanges, and project parties, while the victims are always the investors.

Such conspiracy theories are not worth refuting; they fail to understand that every trader in the open market faces the entire market as their counterpart, and every transaction is watched by everyone in the market. But the retail investors do not care about this; when they lose money, everything looks like a scythe to them.

The money evaporated in the collapse of Terra did not truly vanish; it flowed into the pockets of arbitrageurs and short sellers. However, this was not the violent sell-off that conspiracy theorists imagine; rather, it was due to the unsustainable nature of Terra's model, which clever investors discovered and punctured in time.

Even as early as 2018, when Terra first appeared, Cyrus, an analyst at Scalar Capital, noticed the risks inherent in the Terra model—the death spiral—and asserted that "this project will not succeed" and "they will contribute to each other's demise." It is worth mentioning that Cyrus was also responsible for risk management at MakerDAO.

Four years later, when Terra collapsed, Cyrus stated, "Terra could still grow tenfold, but we punctured this unsustainable bubble," and the source of Terra's bubble lay in the 20% interest rate.

All prosperity carries the seeds of self-destruction.

Terra is a public chain in the Cosmos ecosystem, with its native token being Luna, and it also has a stablecoin, UST.

Users can mint the stablecoin UST by burning Luna, and UST can maintain its peg to $1 because 1 UST can always be exchanged for Luna worth $1.

Note that there are actually three currencies involved here—Luna, UST, and the dollar. The price of Luna is volatile, the price of the dollar is stable (because the value coordinate system is anchored to it), and while UST attempts to peg to the dollar, it is also volatile (this is the key to understanding Terra's pricing mechanism).

In other words, the price-volatile Luna and the price-volatile UST are tied to the same chariot, which laid the groundwork for the subsequent death spiral.

If UST falls below $1, it can still be exchanged for Luna worth $1. For example, if UST is $0.9 and Luna is $120, then 120 UST can mint 1 Luna, while the actual price of 120 UST is $108.

Thus, arbitrageurs would buy large amounts of UST to mint Luna and then sell it for profit. The arbitrage opportunity would only disappear once the price of UST returned to $1.

If UST exceeds $1, then arbitrageurs can operate in reverse—burning Luna to mint UST and then selling it for profit. For example, if UST is $1.1 and Luna is $120, then 1 Luna can mint 120 UST, while the actual price of 120 UST is $132.

So arbitrageurs would buy large amounts of Luna to mint UST and then sell it for profit. The arbitrage opportunity would only disappear once the price of UST returned to $1.

This mechanism seems perfect; how could it collapse? Because it was designed to respond to UST's volatility without considering Luna's volatility. If Luna continues to rise, the above mechanism holds, but when Luna continues to fall, it becomes dangerous.

Once the market expects Luna to decline, Luna holders will certainly burn Luna to mint UST as a hedge, leading to an increase in UST supply and a decrease in price. At this point, arbitrageurs will buy UST to exchange for Luna and then sell it for profit, further driving down Luna's price, thus solidifying the market's expectation of Luna's decline…

Therefore, for Terra to avoid this death spiral, it must maintain market confidence in Luna.

High returns and low risk are contradictory concepts; risk must always match return.

Terra maintained market confidence by launching the lending protocol Anchor in July 2020, attracting traders to burn Luna to mint UST and deposit it with a minimum yield of 19.5%, thus entering a positive cycle. In fact, Luna's price rose from $5 to a peak of $116.

This idea is not problematic, but the minimum yield of 19.5% is clearly problematic, accelerating Terra's descent into the death spiral.

Mainstream lending protocols cannot possibly offer a borrowing rate of 19.5%, so Anchor took the excess collateral from borrowers to mine, using the mining profits to cover the 19.5%. If that wasn't enough, the treasury would have to make up the difference. Of course, if there were excess profits, they would go to the treasury, but this was a rare occurrence.

More importantly, UST had very few real-world use cases; unlike USDT, which has trading pairs on all exchanges and serves as a fiat on-ramp, not many people would actually borrow UST. In fact, Anchor's borrowing rate was only about 20-30%, so no matter how much excess collateral they mined, it was impossible to earn enough to cover the 19.5% yield for all UST depositors, meaning the treasury was continually subsidizing depositors.

The high yield of 19.5% from Anchor indeed stimulated the market to create UST and lock up the created UST. Before Terra's collapse, over 70% of UST was locked in Anchor.

However, the treasury's funds did not appear out of thin air; they were obtained by cashing out or burning Luna to continue subsidizing. Thus, after launching Anchor, the more UST minted, the greater the subsidy pressure, leading to a larger debt bubble.

Therefore, this attempt to maintain market confidence in Luna actually suppressed the price and confidence in Luna.

We saw Terraform Labs (TFL) and Luna Foundation Guard (LFG) continuously injecting funds into Anchor, but even if Terra had not been attacked by short sellers, based on Anchor's treasury reserves at the time, it would have run out by June. However, considering that there would be continued injections, the time left for Anchor should extend for a while, but not too long.

Patience is an extremely rare virtue on Wall Street.

As Terra's debt bubble grew larger, it awaited the right moment to be punctured, which would be when Luna's price could be easily manipulated.

Of course, Terra did not sit idly by; instead, it took advantage of Luna's high price to cash out and continuously bought BTC to serve as reserves. In the long run, the appreciation of BTC could indeed cover Terra's debt bubble (provided Anchor's yield wasn't so high), but they clearly underestimated the urgency of the situation.

On May 8, Terra removed $150 million in UST liquidity from the UST-3Crv pool to deploy 4pool (UST, FRAX, USDT, USDC) on Curve the following week, leaving only $300 million in UST liquidity.

Just one minute later, a new address transferred $84 million in UST to Ethereum and then sold that UST in the UST-3Crv pool ten minutes later, causing a price impact on UST that was clearly much greater than usual.

Under normal circumstances, this would have triggered the arbitrage mechanism that would cause UST to fall below $1—arbitrageurs would buy large amounts of UST to mint Luna and then sell it for profit until UST's price returned to $1. But at this point, the crypto market had slowly entered a bear market. In a bull market, even the slightest wind can cause a storm, while in a bear market, the wind is filled with fear.

The decline of UST triggered a sell-off of UST by whales seeking to hedge, rather than minting Luna for arbitrage, because they were also worried about Luna. After all, there had already been voices in the market suggesting that Luna would enter a death spiral and go to zero, and there were even rumors that this was a self-directed play by Terra.

The actions of the whales increased the supply of UST, and to maintain the balance of liquidity in the UST-3Crv pool, Terra withdrew another $100 million in UST from the fund pool. Additionally, UST's market maker, Jump Trading, sold 700 million ETH to buy UST.

After a series of operations, they finally calmed the panic caused by the whales' actions, bringing UST close to $1, just like how UST briefly dropped to $0.85 during the 5.19 incident last year but ultimately returned to normal.

However, the true intention was not to simply thwart the short sellers; although it seemed that shorting UST had failed, the real goal was to force Terra to sell the BTC it had previously bought with great fanfare. This was just the first round, the beginning of creating panic.

Uncontrolled panic is a force that can completely destroy a powerful empire.

Less than 24 hours later, on the evening of May 9, the second round officially began.

Thinking that this attack had come to a close, they handed the task of fully pegging UST to $1 over to the market. In the eyes of founder Do Kwon, fluctuations of UST below $0.05 did not count as decoupling, so he would not touch the BTC. But as long as UST had not completely pegged to $1, the shadow hanging over investors' heads would not dissipate.

The short sellers first sold a massive amount of UST ($650 million) on Binance, and the rumors from the recent turmoil were still fermenting. UST investors were still on edge, leading to further sell-offs, and the situation began to spiral out of control. Worse still, the UST that had originally been locked in Anchor began to flow into the market, creating significant selling pressure on UST.

Terra only began to use BTC to defend the peg after UST fell more than $0.05. The confrontation at this point was very paradoxical and exciting—Terra was selling BTC to buy UST, while the short sellers were selling UST to buy BTC.

The key to determining the outcome did not lie with Terra or the short sellers, but with the market, which clearly favored the short sellers.

Although Binance seemed to set a floor price of $0.6 for UST and later even suspended UST deposits and withdrawals, Binance could only be considered an off-market assist, which was of no help.

By May 11, under the pressure, UST had fallen to $0.26, knowing that it was supposed to peg to $1. At this point, UST holders had no choice but to directly sell UST, while arbitrageurs would naturally buy more UST to mint Luna and then sell it for profit, further driving down Luna's price, and the panic from Luna's decline would exacerbate the panic over UST.

In short, the death spiral of Terra had begun and was heading toward an irretrievable state; any subsequent market rescue actions would be futile.

In the absence of external pressure, the development of any organization will evolve in favor of its elites.

Looking back at the process of Terra's collapse, it is not difficult to find that there were many opportunities to avoid the current situation.

For example, setting Anchor's yield at a reasonable level, not leaving gaps when withdrawing from Curve, buying BTC and other reserve assets earlier… but all these countermeasures are merely technical fixes. Terra's collapse was written into the code from the very beginning; it was just a matter of when the button for the death spiral would be triggered.

In fact, a closer examination reveals that Terra was a product of the previous era, only rising and falling after the DeFi Summer.

The founder of Terra is Do Kwon, and the entire project is very much in line with his personal style.

Do Kwon was born in South Korea in 1991 and studied computer science at Stanford University in 2010, having briefly worked at Microsoft and Apple. In an interview last year, he stated that in a project team of 40 engineers at Microsoft, only 4 were actually working.

In 2016, Do Kwon returned to Korea to start Anyfi, a project for sharing mobile hotspots, with initial funding of $1 million, mainly for visitors to the Everland amusement park.

This sector was not mature at the time, and when the ICO boom came in 2017, Do Kwon began researching stablecoins and connected with Daniel Shin, who had a similar background.

Daniel Shin graduated from the Wharton School and founded Korea's first e-commerce platform, TMON, in 2010, cashing out for over $200 million a few years later. As a successful entrepreneur, he then began his career as an investor and advisor.

After meeting Do Kwon, they hit it off and founded Terraform Labs, attracting $32 million in investment, including from Binance, OKEx, and Huobi.

On one hand, South Korea's policies were relatively open, and on the other hand, Terra attempted to establish a platform on blockchain that could compete with Alipay, which was a marketable idea at the time.

In 2019, Do Kwon attempted to launch TerraUSD (UST), pegged to the dollar, and TerraKRW (KRT), pegged to the Korean won, along with the payment system Chai.

This was because Do Kwon had encountered the algorithmic stablecoin project Basis, which had closed in 2018 due to SEC allegations after raising $133 million. Do Kwon attempted to continue the unfinished algorithmic stablecoin ideal of Basis.

Moreover, according to sources from CoinDesk, before UST, Do Kwon instructed employees to anonymously launch Basis Cash, which can be understood as another Basis, with Do Kwon being one of the founders known as "Rick," as evidenced by screenshots of internal Telegram groups.

Basis Cash was merely a test project of Terraform Labs, but it attracted significant attention after its launch, reaching a TVL of $174 million, but ultimately fell into a death spiral.

If the outcome of Basis was the result of external forces and thus not a lesson, then Basis Cash already fully displayed the lifecycle of this model. However, it is difficult to understand why this tragic fate played out for the third time with Terra.

The only explanation can be attributed to Do Kwon's personal inflation.

The spiral structure formed by Luna and UST can easily spiral upward but can also easily spiral downward. The way to avoid a downward spiral is to increase UST's reserves and real use cases as much as possible, but this is destined to be a long road.

Do Kwon chose the easiest path from the beginning—using Anchor's high yield to attract investors to buy Luna and mint UST, which has already laid the groundwork for the subsequent collapse.

Terra did rise rapidly, and Do Kwon became a crypto celebrity; he even believed that UST could replace national currencies and other stablecoins.

However, the Terra ecosystem was lacking; there were no DeFi protocols that could truly absorb UST.

He compared Terra to Singapore, aspiring to be a figure like Lee Kuan Yew.

He indeed established a cult-like personal worship on Twitter. There were fervent followers—who called themselves Lunatics and even tattooed their leader Do Kwon on their bodies. There were threatening "others"—with leader Do Kwon belittling and scolding those "poor people." There was a shared grand vision—to bring DAI to zero and even replace fiat currencies.

This cult attracted enthusiastic support from a wide range of people, from newcomers to retail investors to Wall Street institutions, including Binance and Coinbase, which indeed made over a hundred times their profits.

The considerable returns brought by the Ponzi scheme and the fervent worship blinded many, while the construction of Terra's ecosystem became a distant vision, irrelevant to the present.

Conclusion

Do Kwon believed that "even without UST, Terra has an ecosystem worth protecting," thus proposing the Luna revival plan. But for an ecosystem that never truly existed, how can one talk about revival?

From this review, we can see that Terra's collapse was the result of a combination of internal mechanism flaws, inappropriate operational models, the greed of short sellers, the panic of whales, and the acceleration by arbitrageurs.

Every transaction made by every trader in the open market is exposed to the market, watched by everyone in the market. Everyone is both a hunter and prey, and everyone should act according to their ecological niche.

Recently, I revisited "The Great Game: The Rise of the Wall Street Financial Empire," which depicts the repeated rise and fall of financial markets over the past three hundred years. These summarized experiences resonate differently when applied to the recent collapse of Terra, with some being adopted as subheadings in this article, and a few sentences can serve as a summary of the rise and fall of the crypto market.

"The dark days have been cast aside, and a large number of new traders flocking to Wall Street know nothing of that history."

"Human nature remains unchanged; as long as there are emotions of greed and panic on Wall Street, we have no reason to believe that such bubbles will not happen again."

"The game in capital markets and the exploration of the unknown world stem from the same impulse in humanity, for the boundaries of the market are filled with an unknown future."

Finally, returning to reality, I quote a saying from Bezos: "Most people greatly underestimate how remarkable this bull market has been. When the market starts to teach a lesson, the pain is severe."