Terra’s Luna Comes Crashing Back To Earth

A cautionary tale of hubris and greed in the Crypto Wild West

Recent photo of Do Kwon, founder of Terra.

“Look upon my works, ye mighty, and despair” – Do Kwon, probably

It is often said that the market, in the short term, is a voting mechanism, but in the long term is a weighing machine. To that description I would also add that over every timeframe it is also a stage upon which the whole gamut of human experience is played out. And, of course, there is no more uniquely human a characteristic or ageless a theme than that of hubris. Each market cycle brings forth a new cast of poor players who strut and fret their moment upon the stage, and then are heard from no more. Such is the story of Do Kwon, our brash, all conquering hero, who scaled such lofty heights, whose wonderous plans and ingenious machinations dazzled the eyes of so many a VC, and who, for a while at least, appeared set to defy the laws of nature herself.

Stop me if you’ve heard this one before…

It’s a story so familiar as to be a cliché. Enter Do Kwon, the inventor of Terra, young and energetic, outspoken and shameless. Quickly he amasses a fervent following of disciples, loudly proclaiming that the old ways are wrong and he alone knows the path to salvation. The elders, they council caution, and are mocked for their cowardice and insipidity. As the bringer of fabulous wealth and glorious victories to the faithful, the laws of civility and common sense no longer apply to Do Kwon. Do Kwon, who’s overweening pride now offends the gods, thus sowing the seeds of his own destruction. And those whom the gods would destroy, first they make mad.

Do Kwon’s gravity defying economics finally came crashing back down to earth last week, wiping out the saving of tens, if not hundreds, of thousands of people in what ranks as one of the worse financial collapses not just in the history of crypto, but of all time.

Unfortunately, such is the nature of the “get-rich-quick” crypto space that it is particularly vulnerable to false prophets. Whether or not Do Kwon truly believed the message he preached or if he was in on the scam all along is something that will most likely be decided by a jury some day.

So, what exactly happened last week? Do Kwon’s main invention - implemented on the Terra blockchain - was a scheme (for want of a better word) involving two tradable blockchain based tokens/assets hubristically named (have you noticed a theme here?) TerraUST (often referred to as simply UST) and Luna, which were supposed to work symbiotically as their names suggest, in some abstract fashion, like the Earth and Moon celestial system. The first and principal purpose of the Terra scheme was to allow the volatile asset Luna effectively to support the stable asset UST – an oxymoronic sounding algorithmic stablecoin, in its efforts to remain pegged to $1 USD. How is it that 1 UST = 1 USD? Well, unlike other stablecoins such as MakerDAO’s DAI, which has value because each DAI represent a claim on an overcollateralized pool of assets, UST’s peg is maintained by arbitrageurs swapping between UST and Luna whenever it is favourable to do so. The scheme is designed such that 1 UST coin can always be morphed into $1 of Luna and vice versa. So, if UST is trading at < $1 then a trader could buy the UST at a discount and convert it to $1 of Luna, then sell the Luna for a “risk-free” profit. Conversely, if 1 UST is > $1, buying $1 worth of Luna, morphing it into UST - which is trading above $1 and selling the UST again locks in a “risk-free” profit. The system worked marvellously, until, well, it didn’t.

For the longest of time, Terra Cassandras had pointed out the fatal flaw in the machine – it was a stablecoin built on a system that was inherently unstable. While the marketcap of Luna was greater than that of UST, UST could in some theoretical sense be considered to be fully collateralized, however should the marketcap of Luna drop below that of UST, then should anything spook UST holders, in the rush for the exit the peg would break causing a self-perpetuating panic as UST holders rushed to dump their former stable coin for a claim to the diminishing value of the Luna pool. The very act of redemption would mean Luna would hyperinflate, those holding Luna would have no choice but to dump the token to preserve their wealth, hence Luna would enter a death spiral inexorably headed toward infinite inflation and zero value.

The counter argument, straining against the bars of credibility, sounds something like the verbal equivalent of one of those M.C. Escher impossible structures. It goes something along the lines of – it doesn’t matter that there isn’t enough value in the Luna token to back all the UST – because UST isn’t supposed to be backed by Luna anyway! Luna is just used as some kind of benevolent ethereal force, gently guiding UST back towards its peg in times of difficulty. Furthermore, it's not just the Luna marketcap that backs UST, but intangibles like confidence in the entire Terra Luna ecosystem! The entire system was essentially a self-righting roly-poly toy balancing on a tightrope strung over an enormous chasm. When a soft wind buffeted the roly-poly, it bobbed around gently and eventually came back to equilibrium. But when a strong enough gale hits the toy - it gets blown out of its local equilibrium and hurtles into the chasm below, where no amount of gentle guidance can restore the peg. On the 9th of May 2022 a hurricane came for UST, something caused the peg to slip violently, never to be recovered.   

Schematics taken from the Terra design board

As much as this increasingly begins to look like a mirage build on circular logic, there is some method in the madness. After all, since Nixon took the US dollar off the gold standard in 1971, the dollar itself has ever since been “backed by faith” in the US economy. Had Terra Luna managed to bootstrap itself way into being systemically important to the entirety of crypto, then perhaps this argument might hold water. In fact, even more galling is that recently past interviews with Do Kwon have surfaced which seem to suggest that he might have been aware of this and perhaps even it was his plan all along. Bet the farm on becoming too big to fail and now your problem is everybody else’s problem too.

Where this farce turns to tragedy is with the hordes of retail investors, lured by the promise of a near 20% interest rate on UST by many well know (and trusted) actors in the space, including prominent funds (which have since deleted these tweets) who either by naivety or a breathtaking predatory cynicism - threw blood in the water encouraging the feeding frenzy.

After a year of extraordinary returns, the wheels finally came off the wagon last week. First, UST began to slip from the peg, from $1 down to the mid 90c. This had happened before, and the self-righting mechanics of the Luna ecosystem had managed to restore it. But something different happened this time; it’s possible that a large player launched a Soros-style attack on the peg, or maybe Terra Luna’s luck had just finally run out. Either way, UST holders began to panic and Luna’s market cap began to nosedive as holders dumped their bags on the market. Noticing the declining market cap of Luna, in a vicious cycle UST holders began racing even more frantically for the exit, hyperinflating the Luna supply – it was the textbook death spiral playing out exactly as many commentators had warned Do Kwon would happen, warnings which were met with ridicule and insults.

Had you held $1 million worth of Luna on the 6th of May, seven days later you’d be left with $1.20. Many retail investors, following the pied pipers of crypto “influencers” and celebrity hedge fund “managers”, having come to believe that Terra Luna was like a bank account, except with a magical 20% interest rate - lost their life saving.

Yes, that is a log scale

The events of last week rank amongst the top three most catastrophic failures in crypto history; the other two being the collapse of Mt Gox 2013 and the Ethereum DAO hack of 2016. Predictably the usual stopped clock economists, savouring the opportunity to remind everybody they are still alive, crawl out from their ivory towers to pour ridicule on crypto as whole. We’ve had our Lehman Brothers moment, a 60-billion-dollar protocol collapsed to almost zero overnight, taking with it the saving of potentially hundreds of thousands of people around the world. Suicide hotlines were posted on message boards all over the internet and already stories of personal tragedy are starting to appear.

If there is any consolation, unlike Lehman Brothers, the risk of contagion appears to have been mostly contained, at least for the moment – over the coming weeks we will have a better picture of who got caught in the blast radius. The Terra blockchain was built using the Cosmos SDK, and therefore was capable of spreading its contagions into other Cosmos based blockchains – many of whom, hoping to ride the hype wave, accepted Terra’s poisoned gifts without question. Afterall Terra was a Top Ten crypto asset with many big-name VCs singing its praises. Some BTC was purchased by the Luna foundation, perhaps in the dawning realization that underpinning their house of cards might buy them some time. BTC dropped hard last week, either due to the Luna foundation liquidating its holdings or in anticipation of such an event.

One take away lesson from all this for potential investors is that the case for active management remains a compelling one. But investors must choose their managers wisely. Many managers were caught flatfooted last week. As we’ve pointed out in our previous blog post - reliance on market cap, or headlining VC investment, or market sentiment alone in the absence of fundamental analysis of a project’s underlying technology and economics is a dangerous prospect.

Failure appeared to always have been on the card for Terra. Fortunately, the scheme imploded before it got any bigger and dragging down the whole of the nascent crypto world with it. Although the last chapter of this story is yet to be written, we can expect more drama in the coming weeks as Do Kwon and his merry band attempt to launch resuscitation of their failed blockchain. Despite this calamitous week the Terra ecosystem is a vibrant one with some of the best tooling and user experiences (apart from the one where they lost all their money…) in crypto. Its value is not zero and there is something here to be salvaged. But in the end, for Do Kwon and his followers, they’ve run out of road - in shooting for the Moon, they flew too close to the Sun and found that no amount of hustle, ambition or pride trump the laws of gravity, common sense and basic economics. Time to exit stage left.

Do “Ozymandius” Kwon surveys the wreckage of Terra Luna