Breakdown: The Terra Ecosystem Debacle

Terra was once ranked as one of the top blockchains, and its native token, LUNA occupied one of the spots of the top cryptocurrencies in existence based on their market capitalization. Before it suffered from its recent trials, LUNA was sitting pretty at the top ten position with the likes of Ethereum, Bitcoin, and USDT, but time seems to have changed. 

Once upon a time when people heard of LUNA, Tether USD, and Terra, they were intrigued and wanted to become involved. Terra attracted the likes of developers that were creating innovations such as decentralized finance apps and NFT platforms. It was also seen as the home of algorithmic stablecoin, UST, as well as similar stablecoins. The fall of this chain and its innovations have raised mixed reactions from different members of the crypto scenery, regulators, traditional finance, and much more. 

It has continued to beg the question of whether some crypto leaders can get away with a lot of things that wouldn’t have been permitted in the traditional finance world that is highly regulated. 

This article looks at the root causes of the LUNA and UST crashes, and the way forward.  

What are the root causes of Terra’s debacle?

Two tokens, LUNA and UST have always been the major participants in the Terra ecosystem. People could hardly think about this blockchain without thinking of both cryptocurrencies. The major reasons for the collapse will be discussed below.

The depeg of UST

Terra network is the home of a DeFi protocol called Anchor that was known for offering 20% returns to those that deposit their UST with them. With the high returns, more people were incentivized to demand this stablecoin and deposit it in the Protocol. 

During that period when Anchor offered a 20% rate of return, it was incredibly higher than the average interest rate that other platforms gave for depositing tokens with them for a period. Quite a number of people started trooping to purchase UST and deposit it with Anchor to earn a high rate of return.  

Anchor worked well for some time offering the stipulated interest rate above, but in the third month of 2022, it decided to alter the once-favored rate of return. 

The protocol decided that the fixed rate should evolve into a variable rate. It dawned on many that this decision meant that the 20% standard rate was no longer feasible and the variable rate would definitely be below the threshold. 

This decision did not sit well with many and they decided to start selling both tokens that were linked to Terra. When more investors were flooding the market with their UST, an organization that has ties to Terra, Luna Foundation Guard decided to step in to change the tides. LFG was created by the founder of Terra, Do Kwon to help in the affairs of the ecosystem if necessary and it was designated as a nonprofit. With the flooding of both coins, the LFG decided that it was wise to use its bitcoin reserves to salvage the situation, which did not work. 

UST is backed by LUNA and more of the native token of Terra was minted to reduce the rapid drop in value, but this did not work. 

The depegging of the UST was the beginning of the end for the once-favored stablecoin. The issue started on the seventh day of May 2022 when the Anchor Protocol suffered a loss of over $2 billion UST because the holders decided to unstake them from the DeFi protocol. 

Out of the billions that were withdrawn, millions of the stablecoin were sold at the same time, forcing the value of one UST to get to 91 cents, from its initial price of $1. 

When other investors realized that UST had lost its peg and the value had fallen to 91 cents, they decided to sell theirs. 

Since the design of Terra made sure that both UST and LUNA were linked together, the decline in the value of the stablecoin affected LUNA negatively.

The Depeg: Contribution of some companies

Nansen, a blockchain analytics firm has noted that some wallets were involved in prompting the depeg of the UST, and of the wallets was owned by Celsius, a notable crypto lending platform. The analytics company believes that by selling a large amount of the algorithmic stablecoin, it affected UST badly. 

As mentioned earlier, UST’s value is linked to the native token called LUNA, as well as an advanced network of arbitrageurs. It is unlike some other stablecoins that are backed with fiat currencies like the United States Dollar, short term investment instruments in the US, and so on.  

This system made UST a highly decentralized stablecoin compared to its counterparts, but this affected it negatively once the market conditions were not on its side, thereby forcing the value of the UST to fall far below $1. 

Nansen released a report that stated that seven arbitrageurs participated in the depegging of the stablecoin through their act of sending large volumes of UST to shallow liquidity pools on Curve. 

The CEO of Celsius, Alex Mashinsky believes that Nansen made a mistake in its report. He stated on Twitter that “We stated many times we did not cause or benefit from Luna.”

Nansen noted that seven wallets with a large amount of UST decided to remove it from Anchor Protocol and move it to the Ethereum chain using the bridge. They then decided to swap the UST on one of the notable protocols, Curve. They swapped UST for other types of stablecoins. The report stated that they did the aforementioned before the reduction of the percentage of rewards that Anchor offered UST holders.  

By sending a large amount of UST to Curve, the forces of demand and supply went to work, and the value of the stablecoin started changing. When the Luna Foundation Guard, an organization that is linked to Terra found out about this, they tried to revert the damage by adding other types of stablecoins to the pool on Curve Protocol and withdrawing 150M UST from Curve as a way of reducing its supply.

Current Condition of the Crypto Market

Another reason that has been ascribed to the fall of Terra is the crypto market. In recent times, the condition of the crypto market has not been quite favorable, bordering on bearish. Many coins and tokens have lost the values of their all-time high. At the time of writing this and according to CoinMarketCap, the value of Bitcoin and Ethereum were below $30,000 and $2000 respectively, which are a far cry from what they were in the past. 

A school of thought believes that if this situation had happened at a period when the crypto market was fairing well, it may have not degenerated to this stage. Some feel that it was easier for investors to flood the market with UST and LUNA because of the reddish market condition.

The issues linked to the Terra ecosystem also led to downward pressure on Bitcoin and other cryptocurrencies, as they felt a ripple of effects from people losing faith in UST and LUNA.

Structure of Terra

Some people have blamed the structure of the Terra network for the debacle. According to some, creating a link between the algorithmic stablecoin, UST and LUNA was a wrong decision. This meant that if the stablecoin faired badly, the native token of the Terra ecosystem would also be affected. 

Some have claimed that it may have been an attack to force LFG to sell their large stockpile of Bitcoin to protect the UST peg, but this is merely a rumor that has not been confirmed. 

What were the effects of the crash?

The crash of UST and LUNA brought bad tidings for a large number of crypto enthusiasts that held both coins. At the moment, the value of the original LUNA is below 1 cent, which is a mighty fall from its all-time high of more than a hundred dollars. 

This situation wiped the crypto savings of quite a number of people, as many had held both cryptocurrencies for varying reasons. Different communities on social media such as Twitter and Reddit had victims that had sad tales to tell. Some even went as far as threatening to commit suicide.

One of the victims reportedly went to the home of the founder, Do Kwon to harass him, while others had called on the South Korean government to seize the assets linked to the national and use them to repay some of the victims. Some victims have filed lawsuits against the South Korean citizen. 

As a result of the situation, the internal legal department of Terraform Labs reportedly resigned and stopped offering their legal service to the organization and the founder. Do Kwon had to employ the services of an external legal firm. 

Reports have it that the South Korean government decided to launch a study on the effects of cryptocurrencies on the economy after the debacle with Terra. It is expected that a new law will be created to regulate crypto usage in the country called the Digital Asset Basic Act.

This comes after reports that more than two hundred thousand residents in the country invested money into LUNA and UST.

What happened to the Bitcoin held by LFG?

Luna Foundation Guard has been interlinked with Terra since its creation, and the nonprofit held $3 billion worth of Bitcoin before the debacle happened in Terra. During that period, the organization held over 80,000 BTC. It also held other types of major coins like BNB, AVAX, USDC, and USDT. 

When the depeg occurred and the value of UST dropped drastically, the foundation spent a large part of its reserves trying to defend the peg and save UST, but that didn’t work. 

The foundation, through its tweets, claimed that it transferred 52,189 bitcoins to a counterparty, and it later decided to sell an extra 33,206 bitcoins to save UST and Terra. It has a couple of hundreds of BTC in its portfolio. 

The Governance Vote on Terra

After the crash of LUNA and UST, the founder of Terra, Do Kwon made a suggestion to the community. He brought a proposal that requested that a fork be done to create a new chain that was free from the algorithmic stablecoin of UST. This means that a new chain would be formed and differentiated from the existing one. The new blockchain was called Terra, while the old was christened Terra Classic. Their native tokens were to be LUNA and LUNA CLASSIC respectively. 

When this proposal was brought to the community, people were asked to vote and the decision was to be made based on the number of tokens that a person held. 

As part of the proposal, holders of the existing LUNA CLASSIC or LUNC would be airdropped the new LUNA coins. 

Another crucial aspect of the proposal was that the ecosystem would pay those that staked their LUNA coins an APY of 7% to encourage more people to stake. 

The proposal also dictated that if it was chosen that some wallets would be removed from the airdrop events. 

Finally, the proposal contained a token distribution scheme that offered a higher level of support to developers that intended to build on the Terra chain. 

Some people favored it while others felt otherwise. The voting session ended and the community voted for a fork to birth a new chain called Terra. 

Overview of LUNA and LUNA Classic

With the proposal being in swing, two chains will be created from the existing blockchain, which are Terra Classic and Terra. The new chain is called Terra and the old network is christened Terra Classic. 

Though the proposal was chosen by a larger percentage of the community, Terra Classic won’t be left without users, as some members voted against the fork. Some community members believe that opting for a fork was pointless as there were other options to follow. The confidence in the new chain is not as high as one would expect especially since it is still being overseen by Do Kwon.  

Below are some differences between Terra and Terra Classic. 

  • Fork

Terra Chain is the blockchain that will be created from the hard fork, while the existing chain is called Terra Classic. 

  • Tokens 

The native tokens of both networks are different from each other. In Terra Classic, the native coin is LUNC or LUNA CLASSIC, while in Terra, the native token is LUNA. Both coins are different from each other since their blockchains are independent.

  • Algorithmic stablecoin

Terra Classic will still exist with the algorithmic stablecoin. As part of the proposal of the new Terra chain, the network is meant to exist without the algorithmic stablecoin called UST. 

What does this mean for crypto?

 The crypto ecosystem may be innovative, but some people are wary about it because of its almost nonexistent guidelines and volatility. With the sudden crash of the Terra ecosystem and its two popular coins, UST and LUNA, this has reflected poorly on the crypto space. 

It is not surprising as LUNA once sat in the position of the sixth highest market cap token. The fact that billions of dollars could be wiped in a short while from the market cap of a highly ranked cryptocurrency has reflected badly on the market. This is an extreme case of volatility.

Some crypto enthusiasts have also opened their eyes to the concept of insurance coverage in the crypto space. News of some traders being compensated after they took out coverage with some decentralized insurance firms has permeated the crypto terrain. 

There has also been an increasing call for regulation by the government. Some people have noted that if this situation had occurred in the traditional financial space that was highly regulated by the government, the founding team and management of the Terraform Labs may have been arrested and prosecuted. 

This issue prompted the South Korean government to create an emergency study on cryptocurrencies and their effects on the economy. In the future, there is a great chance that more governments will enact laws to protect their citizens from issues like this.