Terra (LUNA/UST): The $40 Billion Death Spiral

On Saturday 7 May 2022, a few very large holders pulled their money out of Anchor, a savings product that paid close to 20% a year on a coin called UST. Over the next week UST, which was supposed to be worth exactly one dollar, fell to a few cents. Its sister coin LUNA, which had traded at $119 a month earlier, fell to less than a hundredth of a cent. Roughly $40 billion of market value was gone, the figure US prosecutors later used in court.

The losses landed on ordinary savers. Hundreds of thousands of people around the world had parked money in UST because it was sold as a stable dollar that paid far more than any bank. South Korean prosecutors alone count about 200,000 victims in that country, with losses of around 300 billion won (about $204 million). The crash also set off the chain of failures that ran through crypto for the rest of 2022.

The founder, Do Kwon, is now serving 15 years in a US prison. His life and the case against him have their own pages. This one is about the machine, because the machine is the point: it was built to fail exactly the way it did.

A dollar backed by a promise

Most stablecoins, coins meant to hold a steady $1 value, work like a deposit receipt. Tether or Circle take in a real dollar and hold a dollar's worth of cash or Treasury bills against every coin issued. UST, also called TerraUSD, held no such reserve in its design. It was an "algorithmic stablecoin": its value rested on a rule written into the Terra blockchain, the public ledger on which both coins ran.

The rule was a swap. At any time, anyone could hand in 1 UST and receive exactly $1 worth of brand-new LUNA, or hand in $1 of LUNA and receive 1 UST. Coins handed in were destroyed ("burned"); coins handed out were freshly created ("minted").

In calm markets this looks clever. If UST slips to 98 cents, a trader buys it cheap, swaps it for a dollar's worth of LUNA, and pockets two cents. Each such trade removes UST from circulation, so the price climbs back to a dollar. Traders hunting small profits do the work of a central bank.

The catch is what stood behind the dollar. Picture a company that promises to redeem its bonds at face value, paid not in cash but in new shares it prints on the spot. That works while the shares are worth a lot and few bondholders ask at once. If everyone asks together, the company prints a flood of shares, the share price collapses, and each dollar of bonds needs even more shares. That loop is the death spiral. Terra's backing was LUNA, and LUNA was only worth something as long as people believed in UST.

The 20% that filled the tank

Demand for UST came largely from one place. Anchor Protocol, launched by Kwon's company Terraform Labs in March 2021, offered close to 20% a year on UST deposits at a time when bank savings paid almost nothing. By early May 2022 Anchor held about $14 billion, roughly three-quarters of all UST in existence.

The yield was not earned. Anchor's borrowers paid far less than its savers received, and the gap was topped up from reserves that Terraform Labs and its backers kept refilling. Like a shop selling every item below cost, it could grow fast and could not last.

Kwon knew the system's weak point. In early 2022 he set up the Luna Foundation Guard, a Singapore non-profit, to buy Bitcoin as an emergency reserve. It spent about $3 billion, mostly from selling LUNA, and held roughly 80,000 Bitcoin by May. So the backstop for the dollar coin was a second volatile asset bought with the first one.

Five days in May

When the big withdrawals from Anchor began on 7 May, UST holders started selling, and UST dipped below a dollar. The swap rule did what it was built to do: holders turned UST into new LUNA and sold the LUNA. The Luna Foundation Guard sent its Bitcoin out to defend the price. It was not enough.

By 9 May UST was at around 60 cents and confidence was gone. Every UST handed in created more LUNA. LUNA's supply went from roughly 350 million coins to more than 6 trillion in a few days, and its price fell from about $80 at the start of the week to under $0.0001. On 12 and 13 May the Terra blockchain was halted twice to stop the printing. By then there was nothing left to protect.

The Bitcoin reserve was almost all spent. Where it went is still argued over in court: the Terra estate says much of it was transferred to Jump Trading, a Chicago trading firm, without a written agreement. Jump denies wrongdoing.

What it set off

Three Arrows Capital, a Singapore hedge fund, had about $560 million in LUNA that it could not sell; it defaulted in June and was ordered into liquidation. Celsius Network, a crypto lender with 1.7 million customers, froze withdrawals on 12 June and filed for bankruptcy in July. Voyager Digital, which had lent heavily to Three Arrows, followed. The confidence that drained out of the market that summer was part of the backdrop to FTX's collapse in November.

Terra itself was restarted on 28 May 2022 as a new chain with a new LUNA. The old chain became Terra Classic, its coin LUNC, and the broken dollar coin USTC. Neither ever came close to its old value.