3 Reasons For Terra's Collapse
After last week’s unparalleled collapse of Terra’s UST stablecoin and its LUNA governance token, crypto investors have been trying to parse out what happened. Formerly ranked #3 by CoinMarketCap, LUNA has now dropped to #211 after losing its U.S. dollar peg. The extent of the carnage could perhaps be summed up with LUNA offloading 100% of its valuation as Terra’s subreddit pinned suicide hotline numbers. So, what happened? Here are the three main factors in Terra’s downfall.
Proposal 20
Terra’s business model is to get investors to buy Luna and deposit it into their lending protocol, Anchor. The funds are then distributed to borrowers at high interest rates, sometimes as high as 20%. The trouble began back in March when Proposal 20 was passed, tying the interest rate to the amount of reserves available.
This meant that as there were more lenders than borrowers, the interest would continue to decline. Proposal 20’s amendment that yields would decline about 1.5 percentage points each month was the exit sign for most investors. The weekend before the collapse, investors took back $2.3 billion causing a now famous dip to occur before Wednesday’s falling knife. In essence, Terra did not have enough borrowers to hold the high interest rate and when Proposal 20 soured the lending incentive, those investors had no other use for Terra’s coin; so they fled.
The Mechanism Broke
The next problem was rooted in how investors exit. Lenders can swap one UST, Terra’s stablecoin, for $1 of LUNA, destroying (burning) UST coins in the process. This causes a margin which other investors take advantage of: when a UST falls below $1, investors can swap it for $1 of LUNA, making a two or three cent profit on each coin. Likewise, if LUNA falls below $1, investors can burn it and create (mint) a new UST, at profit. This is known as the ‘burn-and-mint’ mechanism.
As investors burned UST and minted more LUNA, a backlog of transactions began to occur and LUNA could not mint enough new coins fast enough to balance the UST burn, while keeping its peg to the dollar. The more LUNA that was minted, the more diluted the coin became and the price began to drop.
Market Panic
As the broader market began to see what was happening, more and more people began to sell off UST until it finally balanced out at 13 cents. By then, many people had lost their life savings, their blockchain startup or worse. Terra saw at least $40 billion in its own coffers extinguish in less than 24 hours.
Terra’s CEO, Do Kwon, has announced that his team will fork a new coin, ‘Terra Classic’. However, Mr. Kwon’s plan has already been denounced by Binance CEO Changpeng Zhou, who tweeted his disappointment in how the Terra team were responding to the crisis. Even more damningly, The South Korean government is now calling for Mr. Kwon to appear at a public hearing to explain the causes of the collapse and launch “emergency inspections”.
The fallout continues and it remains to be seen what Mr. Kwon and his team will do to revive not only Terra, but also their reputations.
